Mid-year Update and Company Reports

 

American Express (AXP 49) continues to address two very large opportunities in the credit card issuance market.  First, the U.S. Department of Justice is highly likely to successfully complete the long process of opening the credit card market to competition.  The Supreme Court will rule later this year on whether MasterCard and Visa have restrained trade by prohibiting banks that issue MasterCards and Visa cards from issuing any other cards, such as American Express and Discover.  So far, the courts have ruled for the DOJ on this case at all levels.  MBNA has already contracted to start issuing Amex cards pending completion of the litigation, and other issuers will follow rapidly.  The economic potential is very large for American Express.  MBNA did $100 billion in card billings last year.  If Amex cards do 1/10 of that, Amex will earn $300 million in fees, good for about 10 cents of incremental earnings per share.

 

The second great opportunity is in “Global Network Services,” through which American Express is spreading its cards throughout the world.  For example, the company is partnering with ICBC, the largest bank in China, with 24,000 branches, to issue American Express cards in China.  Amex earns fees while ICBC retains the credit card receivables.  In that manner Amex has little capital investment and no collections in China.  Currently, Amex has 82 such partners in 93 countries.

 

Economic recovery in the U.S. is driving Amex’ other businesses.  Last quarter, travel revenues were up 16% over the previous year and assets under the American Express Financial Advisors unit and American Express Bank were up 28%.  Cards in force were only up 7%, but cardholder loans were up 12%.

 

The company’s long-term revenue growth goal is 8%, while continued focus on profitability supports the earnings per share growth goal of 12 – 15%.  The company appears likely to meet or exceed those goals this year.  Growth beyond 2004 depends on the outcome of the above-mentioned litigation.  A positive outcome should drive growth above these long-term goals for a few years.  Growth risks include the sensitivity of card billings, banking, and investments to economic cycles and terrorism.

 

2004 earnings per share are projected at $2.65 and next year at $3.00.  Intrinsic value is estimated at $40.  Because a favorable outcome of the litigation should drive growth above company goals, the stock is attractive in the low to mid-40’s.  Similar to 9/11, a terrorist attack in the U.S. could drive the stock down to levels I would find attractive.

 

Medtronic (MDT 50) continues its record of sustainable revenue and earnings growth in excess of 15% per year.  With two-thirds of revenues sourced from products developed in the past two years, the company extends its exceptional history of innovation.  Industry demographics are excellent.  Most of the world’s $3.6 billion in healthcare expenditures is spent on the elderly.  Medical technology is extending life span, permitting people to get old enough to become victims of more diseases that cost more to treat.  Depending on the country, the population over 60 years in age will double or triple over the next 20 years.

 

Medtronic is a market leader in huge, underpenetrated markets.  Medtronic modestly leads Guidant (GDT 54) in pacemakers and implantible cardiac defibrillators (ICD’s).  In the U.S. alone, 450,000 people die annually from cardiac arrest.  Many deaths could be prevented and hospital stays shortened by installation of a new class of ICD’s that also resynchronize the beating of at least two chambers of the heart.  Medtronic is close to introducing technology that enables this same device to sense edema.  Fluid accumulation in the lungs can give a two-week warning of a serious heart attack.  It is estimated that there are 1.2 million candidates for ICD’s in the U.S., and that only 10% of these potential patients have them.

 

Movement disorders such as Parkinson’s disease and epilepsy affect 200,000 per year, and market penetration is only 10%.  Incontinence and chronic pain also affect many people.  Medtronic neurological implants address these problems.

 

Medtronic is a leader in the spinal business, offering INFUSE bone regenerative protein, bone cages, artificial disks and numerous devices to treat back and neck problems.

 

Diabetes is a $30 billion worldwide health problem.  In the U.S. alone, 4 million people are insulin dependent.  Market penetration is 20%.  Medtronic’s implantible glucose pump addresses this fast growing disease.  Medtronic is also working on open-loop glucose control and sensing, the object of which is to create an artificial pancreas.

 

Medtronic trails competitors Johnson & Johnson (JNJ 56) and Boston Scientific (BSX 40) in one important business, drug-eluting stents.  Medtronic expects European approval late this year, and U.S. approval late next year.  Medtronic’s excellent Driver uncoated stent will power the Endeavor drug eluting stent effort.

 

Medtronic earned $1.60 in the April 2004 fiscal year, and is projected to earn about $1.90 in fiscal 2005 and $2.20 in fiscal 2006.  Intrinsic value is in the mid-$50’s.  I have followed Medtronic for nearly 20 years.  It is one of a handful of companies that has truly excelled in ethics, coincident pursuit of humanitarian, employee, and shareholder goals, sustainable growth, earnings quality – in short, one of the world’s best-managed companies, an honor to own.

 

AIG (AIG 69) is the largest commercial insurance company in the U.S.  It boasts an outstanding record of sustainable growth, vast worldwide distribution, and broad diversification of risk.  Born in Shanghai in 1919, it is the only non-Chinese life insurance company to own an insurance company in China.  It retains one of the world’s rare AAA debt ratings and raised its dividend three times last year.  The debt rating allows AIG to maintain both the trust of its customers and the competitive advantage of a low cost of capital.

 

AIG is also an international growth play.  It is the largest insurer in Hong Kong, Singapore, Thailand, Indonesia, and the Philippines.  It also owns 9.9% of the largest insurance company in China, Peoples Insurance Company of China, which has 4300 branches, 121,000 agents, and 70% market share.

 

Insurance companies spent the decade of the 1990’s competing harder and harder for business, under-charging and under-reserving for long-tail liabilities.  With this backdrop, insurance stocks were severe victims of 9/11.  Claims mounted into the billions of dollars over the next couple of years.  Steep insurance premium increases followed, in turn driving the 2003 recovery of insurance stocks.  However, the peak of the premium increase cycle has now passed, and the stocks have dropped from last year’s levels.  With the experience of 9/11 still fresh in insurer’s minds, the failure to settle asbestos litigation, and a lack of tort reform, insurers are unlikely to return to the cutthroat competition of the 1990’s soon.  Thus, the current profit cycle should last awhile, and an opportunity may be present in this group of stocks.  AIG dipped as low as $43 after 9/11, recovered to $78, and now is $69.

 

In addition to insurance, AIG has $48 billion of assets under management.  Increased compliance expense is a negative for the value and profitability of asset management companies.  It is also the world’s largest airplane leasing company.  All its planes are leased, 85% to foreign carriers.  International growth prospects are very good, as Chinese airline passenger demand exceeds aircraft capacity.  Although 9/11 hurt the travel business, there is now an enormous pent-up demand for new aircraft, in particular from foreign airlines.

 

AIG earned $3.89 in 2003, and is projected to earn about $4.50 in 2004 and $5.10 in 2005.  The combined loss and expense ratio was 92.43% in 2003, and the general insurance expense ratio was 19.1%.  Intrinsic value is about $75.  Earnings are subject to numerous unpredictable risks, ranging from natural disasters to terrorism.  Predictable risks include class action lawsuits, a lack of tort reform, the viability of economies worldwide, and regulation.  Insurance companies also have a habit of entering periods during which they get overly aggressive in competing for business by under-pricing and under-reserving for risk.  Historically, this company has compounded earnings at 14%, despite the risks, and that is likely to continue for at least several years.

 

Steven L. Ré, CFA                                                                                          July 15, 2004

 

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities.  The above information is from sources deemed reliable but is not guaranteed.  It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is not a guarantee of future results.  Earnings projections often miss, and markets sometimes go down.  The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.