Consumers flocked to the malls in February, propelling same-store sales higher, as we observed in this recent Alpha Now story. Many, if not most, probably charged their purchases on their credit cards —including their American Express cards – meaning that good news for retailers could well be good news for consumer finance company American Express (AXP.N), which has beaten the I/B/E/S consensus estimate in each of the last four quarters.

We now take a closer look at these results to see what may be in store for future profitability. The StarMine Earnings Quality (EQ) model score of 99 indicates that these earnings are being generated from sustainable sources – a positive sign. The company has reported strong cash flows and enjoys operating profit margins that are above the industry median. Although the company has done a good job controlling costs, its strong earnings aren’t based on that alone; it reported revenue of $5.95 billion in the quarter ended December 30, 2011 that was the highest level recorded in more than five years.

Using a computer-driven model, StarMine analyzes the financial statements of American Express Company and more than 33,000 other companies and calculates a proprietary StarMine Earnings Quality (EQ) score for each security. These scores have proved to be reliable predictors of whether a company’s earnings are sustainable over the next 12 months. Expressed on a scale of 1 to 100, with a higher score indicating higher-quality earnings, the StarMine EQ score makes it possible for investors to compare a company’s earnings quality against that of its peers, that of others in the same region or across the entire universe of stocks. Companies with low StarMine EQ scores are likely to have difficulty in sustaining past earnings, while those with high StarMine EQ scores have a higher probability of continuing to deliver earnings at or above current levels, because the foundations upon which they are building those earnings are solid. This evaluation of earnings quality at American Express is the first in a series in which we examine companies across North America that rank either especially high or low by our quantitative earnings quality measure.

Strong cash flows are a key component in order for a company’s earnings to be sustainable. In the case of American Express, net income has been positive and strong for the last three quarters. Even more encouraging is the fact that its free cash flow (FCF) has exceeded net income in all three quarters. That can be seen in the chart below, where the green bars represent quarters when FCF exceeded net income. In fact, the company’s FCF levels are finally back at levels that haven’t been seen since early 2008, before the global financial crisis. In the last quarter, the company reported net income of $1.2 billion, while FCF was $3.5 billion. Earnings backed by strong FCF tend to be more sustainable in the future.

Source: Thomson ONE / StarMine

While American Express’s operating profit margins fell in the midst of the recession in 2009, they recovered in 2010 and have stabilized at a healthy level over the last year, as can be seen by the trend represented by the blue line in the chart below. In the latest quarter, the operating profit margin was 40%, significantly higher than the industry median (represented by the yellow line) of 25%. Operating profit margin is one measure of the operating efficiency of a company.

Source: Thomson ONE / StarMine

Another factor in American Express’s favor is the sign, coming from the StarMine Smart Holdings (SH) model, that institutional investors may increase their holdings of the company’s stock. The Smart Holdings (SH) model is a buy-side analytical process that is predictive of fund managers’ buying and selling behavior over the next 90 days, which awards American Express a score of 93 on a scale of 1 to 100. The higher the score, the higher the probability that institutional ownership levels of the stock will climb in the coming weeks and months. Smart Holdings reverse-engineers the investment behavior of each manager and his or her investment style to determine which characteristics that manager seems to favor, based on the stocks they have been buying and selling. We then aggregate what sectors or types of stocks are most popular across all of these funds to determine what companies from amongst the thousands that are publicly traded around the world, appear to be gaining or losing favor among institutional investors. (Read more about this new model in our recent posting, “Buy-side Forecasting Tool Points to Tech, Consumer Discretionary Stocks.” )

The high SH score of American Express indicates that institutional investors appear more likely than not to boost their holdings in the consumer finance business in the coming weeks. Perhaps it is the company’s strong earnings quality that is helping to make its business more attractive in the eyes of those investment managers?

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