AMERICAN EXPRESS CO quarterly report, Q2 FY2011

American Express Company — Q2 2011 Form 10-Q

Business context and reporting period. American Express is a global payments and travel services company. This unaudited filing covers the three and six months ended June 30, 2011; comparisons are with the corresponding 2010 periods. Unless stated otherwise, amounts are in U.S. dollars.

Financial performance

Metric	Q2 2011	Q2 2010	Six months 2011	Six months 2010
Revenue, net of interest expense	$7.618 billion	$6.805 billion	$14.649 billion	$13.365 billion
Net interest income	$1.151 billion	$1.188 billion	$2.285 billion	$2.495 billion
Provisions for losses	$357 million	$652 million	$454 million	$1.595 billion
Income from continuing operations	$1.295 billion	$1.017 billion	$2.472 billion	$1.902 billion
Net income	$1.331 billion	$1.017 billion	$2.508 billion	$1.902 billion
Diluted EPS, including discontinued operations	$1.10	$0.84	$2.07	$1.57

Q2 revenue net of interest expense rose 12%; net income increased 31%. Six-month revenue rose 10% and net income increased 32% year over year.
Q2 pretax income was $1.765 billion, approximately 23.2% of revenue net of interest expense, versus $1.595 billion, approximately 23.4%, in Q2 2010. The comparable six-month ratios were approximately 23.9% and 21.3%. These are calculated ratios, not company-reported margin measures.
Q2 card billed business increased 18% to $207.6 billion (15% on a constant-currency basis). U.S. billed business grew 14%; billed business outside the U.S. grew 27% as reported and 15% on a constant-currency basis. The average discount rate edged down to 2.54% from 2.56%.
Q2 total expenses rose 21% to $5.496 billion. Rewards expense increased 35% to $1.613 billion; salaries and benefits rose 21% to $1.595 billion. Q2 effective tax rate was 27%, versus 36% a year earlier; it included a $102 million benefit from resolution of prior-year tax items.

Balance sheet, cash flow and capital

At June 30, total assets were $147.796 billion, total liabilities $129.591 billion and shareholders’ equity $18.205 billion. Cash and cash equivalents were $23.082 billion.
Long-term debt was $61.395 billion, down from $66.416 billion at December 31, 2010; short-term borrowings were $3.702 billion. Customer deposits increased to $32.291 billion from $29.727 billion.
Net cardmember receivables were $39.728 billion and net cardmember loans $56.189 billion. Loan loss reserves fell to $2.560 billion from $3.646 billion at year-end; receivables reserves rose to $415 million from $386 million.
For the first six months, operating cash flow was $4.389 billion, investing cash flow was $5.507 billion and financing cash flow was negative $3.273 billion. Cash and cash equivalents increased $6.726 billion to $23.082 billion. Investing cash flow included a $3.476 billion decrease in restricted cash.
Management reported $20.0 billion of cash and readily marketable securities available to fund maturities after specified adjustments, against $16.9 billion of scheduled debt and certificate-of-deposit maturities over the following 12 months.
Reported capital ratios at June 30 included a 12.3% Tier 1 risk-based ratio, 14.3% total risk-based ratio and 10.1% Tier 1 leverage ratio. The company estimated Basel III rules, if then in effect, would reduce Tier 1 risk-based and Tier 1 common ratios by about 40 basis points and the Tier 1 leverage ratio by about 160 basis points.

Material changes and management commentary

Credit performance improved: Q2 cardmember-loan provisions fell to $176 million from $540 million, and the Q2 loan principal net write-off rate declined to 3.1% from 6.0%. Management said reserve releases would likely contribute less to results going forward.
Net interest yield on cardmember loans fell to 9.0% in Q2 from 9.6%; the six-month yield was 9.1% versus 9.9%. Management attributed the decline to lower revolving balances and fewer balances at penalty rates, partly reflecting the CARD Act and improved credit performance.
Rewards costs increased substantially due to higher spending and co-brand expense, higher redemption rates and a shift toward more costly redemptions. Management said these factors raised both current-period rewards expense and the liability for unredeemed points.
Management described spending and credit trends as strong, while noting uncertain economic and regulatory conditions, more difficult comparisons with 2010, and the end of MasterCard settlement payments after Q2. The final Visa settlement payment was expected in Q4. The company said it was working to slow operating-expense growth as it exited 2011 and entered 2012.
The company’s stated long-term financial targets, on average and over time, were at least 8% growth in revenue net of interest expense, 12–15% EPS growth and ROE of at least 25%. If both EPS and ROE targets are achieved, it aims to return about 50% of capital generated to shareholders over time. These are targets, not specific near-term guidance.
During Q2 the company repurchased about 15.0 million shares at an average $50.14 per share. Q2 restructuring and other severance charges included $4 million for planned servicing-network consolidation and a separate $44 million of severance-related reengineering costs. Expected 2011 servicing-network charges were $60–$80 million pretax.
The company acquired a controlling interest in Loyalty Partner for $616 million in Q1 and may acquire the remaining interest within five years; its estimated fair value was $150 million. The final purchase-price allocation remained pending.

Risks, contingencies and unusual items

Management estimated reasonably possible losses from certain legal proceedings and governmental examinations at zero to $520 million in excess of accrued liabilities, where estimable. It said this was not a maximum exposure and that outcomes could materially affect results in a particular period.
Significant legal matters include U.S. Department of Justice and state attorney general antitrust litigation concerning merchant anti-steering rules, as well as related merchant actions. The company said it believed it had meritorious defenses. It reported no pending matter expected to materially affect consolidated financial condition or liquidity based on then-current knowledge.
Management cited uncertainty around European sovereign creditworthiness and possible U.S. sovereign credit downgrades, funding access and costs, credit ratings, competition, card-network pricing, consumer spending, and regulatory changes including the Dodd-Frank Act, Basel III and CARD Act requirements.
Tax items were unusual: Q2 continuing-operations tax included a $102 million prior-year benefit; discontinued operations included a separate $36 million tax benefit related to the former American Express Bank. Six-month net income therefore included $36 million of discontinued-operations income.
The filing notes a $353 million reclassification on the December 31, 2010 balance sheet to correct a cash and other-liability misclassification. The company reported that its disclosure controls were effective and no material change in internal control over financial reporting occurred during the quarter.

Important facts for investors to verify

Whether credit quality remains strong as reserve releases diminish, and how loan write-offs and reserve coverage evolve.
Whether rewards expense and the unredeemed-points liability continue to rise, and whether card spending growth supports those costs.
How loan yields, CARD Act effects and the changing mix of revolving balances affect net interest income.
Whether liquidity and planned funding remain adequate for the $16.9 billion of stated 12-month maturities, including access to securitization and committed facilities.
Developments in anti-steering litigation, other legal contingencies and tax examinations, including potential outcomes not captured in the estimated loss range.
Progress toward the company’s long-term financial targets, expense-growth plans, restructuring completion and the expected final Visa settlement payment.