American Express Hiding?

Typically I get a more indepth understanding of a company the longer I study it; this is part of the joy of learning. Not so with American Express (AXP).

Last year, AXP spun off American Express Financial Advisors (AEFA). I supported this move believing the narrowed focus and less capital intensive business model would benefit AXP. But I never imagined that the financial statements would become more opaque.

The first baffling issue is AXP's focus on increasing the return on equity (ROE). In the first paragraph of the 2006 shareholder letter, CEO Kenneth Chenault writes, "In the fourth quarter, we raised our ROE range from 28-30% (to 33-36%), reflecting both our performance since the spin-off and continued confidence in our growth potential."

While ROE provides an excellent way to gauge the capital efficiency of a business, the measure has some real limitations. The most severe limitations of ROEs occur when share issuance or repurchase is high. If large share repurchases occur at a market value in excess of book value, the ROE is raised, almost regardless of business performance. I can point to numerous examples of a poorly performing business with a rising ROE.

Later, in the same letter, the CEO points out that billed business grew by 16%, driven by a 9% increase in cards accompanied by an increase in average spending per card of 7%. From this information, many calculations are straightforward. Yet, my computed numbers increasingly vary from those reported by AXP.

In 2006, AXP reported spending per card to be $11,201 versus my calculation of $8,984. Starting in 2001, my calculation was less than 10% apart, but is now 15%. The same widening has occured in the reported discount rate (2.57%)versus the computed discount rate (2.31%) In 2001, my variance was 8 basis points, but has now moved to 26, resulting in the average discount revenue per card reported at $288 versus a computed $208 per card!

Yet, the worst discrepancy is between reported net fees per card ($35) versus my computed net fees per card ($32). In 2001, my variance was $6 more, but that has now moved to $3 less. This example seems very strange. The net fees on the income statement has not moved significantly for the last six years, and yet the number of basic cards issued has grown strongly. How is it possible that net fees per card have not moved down then?

Despite these issues which have arisen during their transition, I continue to believe that AXP has one of the best franchises in the world and have included a picture of myself happily using My Blue Card in Moorea.

Fairwell to First Data Corporation

In September 2006, First Data Corporation (FDC) spun off Western Union. Then a few weeks ago, FDC announced that it was being bought out by KKR. Now I am moving FDC to the "gone (private), but not forgotten (or public yet - again)" category.

I have studied FDC since the Great Tech Bubble. As we saw the use of more plastic and less cash, a colleague of mine asked, "who makes money on that?" I found out that FDC did - in a big way.

FDC dominates merchant-processing, processing over 50% of the U.S. Visa and Mastercard transactions. FDC's market share in a high fixed cost business gives FDC an enormous competitive advantage. On top of that, FDC is in the best business in Texas (besides Dallas and Houston tollways): helping Mexicans send U.S. earned money back to Mexico. FDC's Western Union dominates this business.

Unfortunately, I never became an owner of FDC stock. My ailment might be considered psychosomatic: I get nosebleeds at p/e ratios over 20. With FDC's average p/e ratio hovering above 25, "bargain" opportunities arose when the p/e dropped all the way to 19 - twice in six years. Nevertheless some investors dove in where I feared treading. One of my cachamim was among them: David Swensen.

Most people had not heard of Mr. Swensen until a recent NYT article featured him. The article told how Yale's endowment had generated an investment return of 16.3% per year under Mr. Swensen's leadership. Such an investment record would send lesser individuals into managing a hedge fund with at least a "2 and 20" fee. Rather than working for Yale for a little over $1 million, he could get paid tens or hundreds of millions of dollars.

But that's not Mr. Swensen. He has explained that his motivation is a "mission" to "make money for financial aid for students." Last year, Yale University's president analyzed their top donors and put Mr. Swensen at the top with a "donation" of $7.8 billion. That sum is the amount of outperformance he has generated relative to his peers at Harvard et al.

His sense of mission translates to what he expects of others. When evaluating a money manager, Steve Cohen, who received a 50% performance fee, he commented "the fees alone are enough to say that I don't want a meeting and there are enough people who put together fair deals." Further, he doesn't go for the "trust me" method of "black box" investing, such as ESL Investments.

The article also describes Mr. Swensen as "not afraid to go where other people don't" which is exactly what I found with his investment in FDC.

Equipped with perfect knowledge of what happened, I went back to my research and reevaluated my calculations. For 2007, Western Union still looks like it's worth $24. The rest of FDC still looks like it's worth $28. Together, they're worth $52. 75% of $52 is $39 - a p/e ratio of 15 - something it never got close to. Maybe it will next time around or maybe, by then, I'll better understand why Mr. Swensen thought he could pay a higher price.

Biotechnology's Moat

On a recent excursion, I got a new "wise one" on the differences between the biotechnology industry and traditional pharmaceutical companies. The primary difference is that biotechnology companies focus on "large molecules" and pharmaceutical companies focus on "small molecules." I understood that prior to my recent discussions. But, I did not understand the deeper difference in their competition with generics.

In the 2006 annual report of Amgen, CEO Kevin Sharer writes, "Biosimilars, or follow-on biologics as they are called in the U.S., are not in any way comparable to generic pharmaceutical products. Protein-based medicines cannot be copied in the way that small molecules can be. Their production is complex, and their safety must be ensured through rigorous processes and tests." Without my new insights, I could not have deciphered this statement.

Essentially, both small and large molecules must be patented as a "utility patent." Their patents is published. Small molecules are not only easily understood, but more importantly, easily produced. Large molecules, even when perfectly understood, are affected by their "complex" method of production. The method of production is not disclosed as part of the patent, but only to the FDA as part of the "rigorous processes and tests." Because of the complexity of production, generic copycats cannot generate an easily approvable without replicating these "rigorous...tests." These tests raise the cost of production significantly. That moat is significant.

Tim McElvaine

Readers of my blog know that I have a list of cachamim or "wise ones." My goal is to "get dirty from the dust of their feet" - so close would I like to study their wisdom. Tim McElvaine is on the list. He is a Canadian investor. Recently, I came across a brilliant statment he made: "buy on the assets and sell on the earnings." This insight is profound and rewards reflection.

Is Big Pharma Inefficient?

A NYT article (2/11/2007) titled "It's Alive! Meet One of Biotech's Zombies" describes insight into the biotechnology industry. At first glance, it appears that biotech companies bring nimble, entrepreneurial qualities to the pharmaceutical industry which are lacking within Big Pharma (large traditional pharmaceutical companies). The article shows that's not true.

The article quotes Arthur D. Levinson, chief executive of Genentech, as saying "biotechnology has been one of the biggest money-losing industries in the history of mankind.” He estimated that the biotech industry as a whole has lost nearly $100 billion since Genentech opened its doors in 1976. Only 54 of 342 publicly traded American biotech companies were profitable in 2006, according to Ernst & Young.

The article also offers insights from an industry observer. Gary P. Pisano, a Harvard Business School professor has put forth a new book, “Science Business: The Promise, the Reality and the Future of Biotech,” in which he argues that the biotechnology industry is inefficient — or at least no more efficient at drug development than Big Pharma.

If the biotech industry is no more efficient than Big Pharma, then their presence is merely a version of the "lottery principle" articulated by Alan Greenspan during the roaring 90s and not a superior way to invest in the health care industry.

Leading Grocer: SYY

Sysco Corporation (SYY) is the leading grocer to restaurants. "Eating out" (foodservice) and "eating in" (retail) now make up roughly equal shares of the total U.S. food dollar with each grossing (a word derived from grosse, meaning twelve dozen, that also led to the word grocery) about $500 billion.

Eating out is a broad category, including schools, hospitals and supermarket services. For years foodservice was gaining share from retail, but has levelled out since 1998. Excluding supermarket and fast food categories, SYY has roughly 15% market share of selling groceries to foodservice, a $200 billion category.

SYY gets slightly over 50% of its revenues and most of its profits from "street customers," a term it uses to describe independent restaurants. The independent restauranteur is declining in the take out category, but is thriving in the full-service arena. SYY is a valuable ally to these customers, equipping them with the benefits of technology that would normally be available only to large scale buyers such as McDonalds.

Viewed in these terms, SYY is similar to Wal-Mart (WMT), another "leading grocer" with over 24% market share. Just as SYY expands the purchasing power of these "street customers" with scale and technology, so does WMT expand the purchasing power of its customers with scale and technology. However, SYY's customers use the expanded power for competitive purposes in business, while WMT's customers use that power to enjoy a wider range of products and services.

Based on this comparison, I tried to compare the long term stock price performance of the two companies. This graph shows the result:

Through 2003, these two stocks had similar performance, but have diverged since then. Looking at their financials, I saw they had similar results. However, the market gives SYY a P/E of 24 that is significantly higher than WMT's P/E of 18. In fact, past divergences in price are also mostly caused by P/E (market value) differences, not operating ones. (Here it appears that WMT has compelling value versus SYY.)

Interesting to me, SYY has almost 9,000 trucks while WMT has about 7,000 trucks, even though the gross revenues of WMT (in the U.S.) are almost eight times greater. This difference indicates that SYY could have some real improvements in the distribution area with its much anticipated redistribution centers (RDC). Look at the following graph the company has supplied:

If trucking times improve as indicated, either less trucks will be required or a greater volume will be moved with the same number of trucks. In either case, SYY will have moved another step towards helping its customers compete.

Hedge Hog?

As I wrote in an earlier blog, I continually look for cochamim, "wise ones" to learn from. One good way is to look for the footprints in the sand and James H. Simons is making big footprints. In fact, his footprints are so large that I'm leery about their accuracy.

James H. Simons is an accomplished mathematician turned hedge fund manager. For 2005, he was the top money-maker with his reported take-home pay to be $1.5 billion. The math for his compensation does not require a Ph.D; he earns a 5% fee plus 44% of outperforming his benchmark. (And to think that I was squeamish about 2% plus 20% of outperformance!) As if that compensation number is not mind-boggling enough, his investing techniques are even more alien.

He is a "high frequency" hedge fund manager. This new breed uses advanced mathematical and scientific processes to detect the "visible hand" in the tick by tick trades in the stock market. This relatively unknown trader's firm is reputed to make over 10% of the daily trades on the NASDAQ.

His returns are extraordinary. Apparently he has exceeded 35% per year for over 20 years. But these returns are not verified nor are his processes public. For years, the claim has been made that his firm, Renaissance Technologies, would not market, nor even need to market. Despite those claims, Renaissance cranked up the marketing and moved from $5 billion to $16 billion in assets under management (AUM) by the end of the year 2006.

Was $1.5 billion in compensation not enough?