Yesterday, American Express Company (AXP) reported third quarter income from continuing operations of $1.1 billion or 90 cents per share, well ahead of the Zacks Consensus Estimate of 85 cents. Results in the year-ago quarter were $640 million or 54 cents, excluding a loss of $2.0 million or one cent per share from discontinued operations. However, the results from discontinued operations were nil during the reported quarter.

The significant surge in earnings for American Express was attributable to an increased usage of cards with lesser defaults as consumers resumed their spending at a level similar to the pre-recession period. However, strong growth in the top-line and substantial reduction in provision for losses was partially offset by higher-than-expected operating expenses and higher tax rate.

American Express’ card members’ spending increased 14% over the prior-year quarter. The increase came from corporate cards, cards issued by its bank partners and premium co-branded cards. 

Behind the Headlines 

American Express posted total revenues, net of interest expenses, of $7.03 billion, up 17% year over year from $6.02 billion. This also came in favourably as compared to the Zacks Consensus Estimate of $6.79 billion.  The revenue augmentation reflects the consolidation of securitized card member loans and related debt onto the balance sheet in the first quarter of 2010.

Additionally, the increase in revenues was supported by higher spending and higher travel commissions by card members, offset by a smaller loan portfolio due to lower interest income and lower yields on both the securitized and non-securitized portions of the portfolio. 

Net interest income grew 57% to $1.18 billion as opposed to $754 million in the year-ago quarter. However, over the last several quarters, American Express has generated lower interest income on account of lesser borrowing by card members and rising payment of their outstanding debt.

Provisions for losses were $373 billion, down 69% from $1.2 billion in the prior-year quarter, although lending volumes continue to remain sluggish. The year-over-year decrease in provisions for losses was driven primarily by continued improvement in credit quality on the charge and credit card portfolios.

Total expenses of American Express mounted to $5.0 billion in the third quarter of 2010, up 28% year over year from $3.9 billion, reflecting growth of investment in business building initiatives along with higher rewards costs. The effective tax rate was 33% against 30% in the year-ago quarter.

Segment Results

U.S. Card Services reported a net income of $595 million, substantially up from $158 million incurred in the prior-year quarter. Total revenues net of interest expenses increased 23% year over year to $3.7 billion from $3.0 billion.

International Card Services’ net income came in at $153.0 million, up 15% from $133.0 million in the year-ago quarter. Total revenues net of interest expenses were $1.2 billion, almost flat with the year-ago quarter.

Global Commercial Services’ net income increased 56% to $159.0 million from $102.0 million in the prior-year quarter. Total revenues net of interest expense increased 17% year over year to $1.1 billion from $975.0 million.

Global Network & Merchant Services reported a net income of $259.0 million, up 4% from $248.0 million in the prior-year quarter. Total revenues net of interest expense increased 15% year over year to $1.1 billion from $976.0 million. The company’s billed business continued to witness improvement in the U.S. and beyond since the fourth quarter of 2009.

Corporate & Other reported net expenses of $73.0 million compared with a net income of $1.0 million a year ago. Results of the year-ago quarter included a non-recurring $180 million ($113 million after tax) benefit associated with the company’s accounting for a net investment in consolidated foreign subsidiaries. 

Capital and Profitability Ratios

As of September 30, 2010, American Express’ return on average equity (ROE) was 25.9%, up from 11.7% in the year-ago quarter. Return on average common equity (ROCE) was 25.6%, up from 10.4% in the year-ago quarter.

As of September 30, 2010, American Express held cash worth $21.0 billion. While total assets were $146.0 billion as of September 30, 2010, total shareholders’ equity was recorded at $16.0 billion.

Comparison with Competitors 

Rival card company Capital One Financial Corporation (COF) also reported its second quarter results concurrent with American Express’ earnings on October 18, 2010. Capital One’s third-quarter income from continuing operations were $1.79 per share, substantially ahead of the Zacks Consensus Estimate of $1.12. This also compares favorably with earnings of 96 cents in the year-ago period.

Another peer, Discover Financial Services (DFS) also reported a third quarter profit from continuing operations of 47 cents per share on September 20, well ahead of the Zacks Consensus Estimate of 35 cents. However, this was below the $1.07 per share recorded in the year-ago quarter.

Other competitors of American Express, such as Visa Inc. (V) and MasterCard Inc. (MA) are yet to report their quarterly results. While Visa will report its fiscal fourth quarter earnings after the market closes on October 27, 2010, MasterCard will report its third quarter earnings before market opens on November 1, 2010.

Our Take

American Express has pulled itself out of the recession more quickly than its rivals, owing to its creditworthy customers. Moreover, less reliance on revolving credit and back-end fees has helped gain competitive advantage for the company while also improving its overall risk profile. Besides, there has been an impressive recovery in credit trends, with increased card spending over the last few quarters.

However, we remain concerned about the challenging regulatory economy and the impact of new regulations on the card industry. We fear that the new regulations under the CARD Act of 2009 are expected to make American Express’ credit cards costlier and will in turn result in lower interest income and loan fee income. Besides, the volatile economic outlook raises near term caution. Hence, we remain Neutral on the stock.

 
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