Discover Still A Little Underappreciated

By Stephen D. Simpson, CFA | December 19, 2011 AAA

Discover Financial Services (NYSE:DFS) is really no longer the plucky up-and-comer. It's getting to the point where merchant acceptance of the Discover card is much more common than not, and the company is certainly a viable alternative to American Express (NYSE:AXP) when it comes to closed-loop systems. That said, the company still lags MasterCard (NYSE:MA) and Visa (NYSE:V) meaningfully, and investors have to balance out the potential benefits of future growth and M&A with the credit risks inherent to the business model.

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A Solid End to the Year
Discover's fiscal fourth quarter results ended the year on a relatively strong note. Revenue rose 13% as reported, with net revenue rising almost 23% from the year-ago level. Although the company's net interest income and margin was a little sluggish, that had a lot to do with student loans that the company acquired. Other metrics were pretty solid; receivables were up about 1%, credit card loans were up 3% and card sales volume was up 8% from last year.

Expenses and credit information were also relatively positive. Expenses grew a little less than 7%, with most of that coming from higher wage and benefit costs. Credit trends continue to improve; net charge-offs fell 62 basis points sequentially to 2.81%, while delinquencies fell slightly to 2.3%. All in all, pretax operating income jumped 40% from the year-ago period. (For related reading, see Store Credit Cards: Do The Incentives Pay Off?)

Plenty of Worries Left to Address
It's not hard to conjure up a meaningful roster of things for investors to worry about at Discover. Competition is always a problem and banks like Citigroup (NYSE:C), Capital One (NYSE:COF) and Bank of America (NYSE:BAC) have the advantages of working with Visa and MasterCard and promoting their cards to their more or less captive depositor base.

What's more, credit and customer usage are both important to Discover's growth trajectory. If consumer spending slows, so will this company's momentum. On the credit front, though credit card delinquencies are getting better at most issuing banks, there is the specter of student loans going sour. Since commercial real estate lending defied the so-called experts and failed to collapse like residential mortgages, attention as since turned to student lending as the next debt bubble to go "pop."

Last and not least is how the company will use its capital. Perhaps it's proof that Wall Street is never happy for long; while investors fret that major banks don't have capital to return to shareholders, the worry with Discover is how they'll use that surplus capital. While management has been good about sharing with shareholders, further M&A makes quite a bit of sense, both in buying loans and expanding its payments business.

The Bottom Line
With partners like Wal-Mart (NYSE:WMT) and Amazon (Nasdaq:AMZN), Discover has the exposure it needs to be a viable competitor with the three other major credit card brands. The problem with Discover, though, is that so much of their earnings comes basic lending activity (the spread) whereas most of its competitors profit largely from fees. (For related reading, see Understanding Credit Card Interest.)

In any case, Discover looks undervalued and underappreciated. It's not going to make an investor rich quickly, but it should be a solid GARP name for years to come.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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