Is American Express Understating Earnings?

Next week American Express Co. (NYSE:AXP) will be announcing its Q3 earnings. What should investors expect with regards to American Express Co. (NYSE:AXP) accounting practices and reserves? Ahead of the American Express (AXP) earnings announcement, CapitalCube assesses the Earnings Quality for the company based on data over the last five years.

Today’s blog wraps up our focus on American Express Co. (AXP) for this week. CapitalCube’s earlier articles on the subject included: American Express (NYSE:AXP): Playing cards with Wal-Mart (NYSE:WMT), American Express Co. (NYSE: AXP): M&A and Dividend assessment, American Express (NYSE:AXP): Two star dividend?.

Our company analysis are always peer-based. We compare AXP stock to its peers in the Financial Conglomerates sector, namely:  JPMorgan Chase & Co.(NYSE:JPM), Visa Inc. (NYSE:V), Citigroup Inc.(C), Bank of America Corp (NYSE:BAC), MasterCard Inc. Cl A (MA), Capital One Financial Corp. (COF), Discover Financial Services (DFS), and Cielo S/A (CIEL3).

Earnings Quality

Earnings: From Accounting or Cash Flow?

Net Income = Net Operating Cash Flow – “Accruals”

Accruals are estimates by company management of non-cash expenses, assets and liabilities that are recognized before they are paid. They are calculated as net operating cash flow less net income.

The analysis of accruals can help signal possible earnings management of reported net income and EPS results. For example, ‘Over-Accrued’ can signal under reported net income and/or the building of balance sheet reserve accounts, while ‘Under-Accrued’ can signal inflated Net Income results and/or release of balance sheet reserves to aid reported earnings.

Recent trend for AXP-US’s accruals

The annual trend suggests that AXP-US’s accruals to revenue ratio continues to trend upward and is above (but within one standard deviation of) its four-year average accruals to revenue ratio of 16.5%. Though its accruals to revenue ratio has remained relatively stable at 17.3% compared to 2010, its peer median has increased to 17.3% from 16.7% during this period. Relative to peers, accruals to revenue ratio fell 0.6 percentage points.

On a quarterly basis, AXP-US’s accruals to revenue ratio continues to trend downward and is below (but within one standard deviation of) its four-quarter average accruals to revenue ratio of 24.9%. While its accruals to revenue ratio decreased to 23.2% from 26.6%, its peer median increased during this period to 21.3% from -7.5%. Relative to peers, accruals to revenue ratio fell 32.2 percentage points.

Accounting Quality

Financials suggest possible understatement of net income.

AXP-US’s net income margin for the last twelve months is around the peer median (15.0% vs. peer median of 16.4%). This average margin and relatively conservative accrual policy (23.7% vs. peer median of 18.3%) suggests possible understatement of its reported net income.

Management of Reserves

AXP-US’s accounting suggests a relatively strong buildup in its reserves.

AXP-US’s accruals over the last twelve months are positive suggesting a buildup of reserves. In addition, the level of accrual is greater than the peer median — which suggests a relatively strong buildup in reserves compared to its peers.

Key Items Impacting Cash Flow

Accounts Receivable, Intangible Assets and PP&E have the most material impact on the movement of net income.

We assess the impact of various categories on the cash flow of the company by performing a variance analysis. For each category, this variance analysis measures the movement between the current and previous periods, normalized for the size of the company (e.g. days outstanding or percentage of revenues). This normalization eliminates any movement attributable to period-by-period growth and helps isolate the impact of any accounting policy changes the company might have made in recording the values in each category.

The chart below shows the impact of the top accounting categories on American Express Co.’s cash flow for the current quarter. We consider both positive and negative impacts on the cash flow since the categories could have either decreased or increased the reported net income.

The table below details the impact of the major accounting categories on American Express Co.’s net operating cash flow for the current quarter. While we have identified the major accrual categories, and conduct several tests on this standardized set, it should be noted that companies can sometimes have a non-standard accrual item that has a higher impact on the difference between net operating cash flow and net income.

Item	Latest Quarter	Previous Quarter	Impact On Cash Flow (mn)	Impact On Cash Flow (%)
Accounts Receivable DSO	469.4	264.3	(19,184.1)	(579.6)
PPE DSO	36.8	37.9	98.2	3.0
Intangible Assets DSO	0.0	24.0	2,246.5	67.9
SG&A DSO	26.8	26.8	1.2	0.0
Tax Rate (%)	28.7	29.2	29.9	0.9
Restructuring Expense (% Revenue)	N/A	N/A	N/A	N/A