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Credit Card Companies Are Plastic Gold: But Which Company is the Best Buy?

Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For the last several years, the long-term trend toward a cash free society has lead to tremendous capital gains for shareholders of credit card companies.  The figure below shows the outperformance of American Express (NYSE: AXP), Discover Financial Services (NYSE: DFS), MasterCard (NYSE: MA) and Visa (NYSE: V).  It is expected that this trend has room to run, particularly in many emerging markets.  Thus identifying reasonably priced companies with exposure to emerging markets should make for an excellent long-term investment thesis. 

<img src="/media/images/user_14730/dfs_large.png" />
 

Out of the four companies shown above, Discover appears to be the winner, balancing long-term revenue growth with a reasonable ttm p/e valuation, lower price/sales and price/book valuation and excellent gross profit margin.  The business model of American Express and Discover is somewhat different from that of MasterCard and Visa.  The former hold the underling loans on their books, while the latter have a payment based “toll-road” model in which they collect a fee on the transaction without exposure to the underlying loan.  In this sense, MasterCard and Visa are lower risk, which is reflected in a lower beta.  However, it is hard to argue that these companies are not fully valued at the present time with ttm p/e values of 30.2 and 71.3, respectively.  Discover, on the other hand, has good 5-Year revenue growth and an excellent gross profit margin.  While revenue growth trails that of MasterCard and Visa the lower valuation seems to more than discount somewhat lower revenue growth. 

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>TTM P/E</p> </td> <td> <p>Price to Sales</p> </td> <td> <p>Price to Book</p> </td> <td> <p>Gross Profit Margin</p> </td> <td> <p>ROE</p> </td> <td> <p>5 Year Revenue Growth</p> </td> <td> <p>Beta</p> </td> </tr> <tr> <td> <p>AXP</p> </td> <td> <p>13.81</p> </td> <td> <p>2.027</p> </td> <td> <p>3.479</p> </td> <td> <p>14.85%</p> </td> <td> <p>26.36%</p> </td> <td> <p>3.13%</p> </td> <td> <p>1.82</p> </td> </tr> <tr> <td> <p>DFS</p> </td> <td> <p>8.64</p> </td> <td> <p>2.166</p> </td> <td> <p>2.166</p> </td> <td> <p>86.49%</p> </td> <td> <p>25.84%</p> </td> <td> <p>44.98%</p> </td> <td> <p>1.43</p> </td> </tr> <tr> <td> <p>MA</p> </td> <td> <p>30.2</p> </td> <td> <p>9.001</p> </td> <td> <p>9.391</p> </td> <td> <p>40.25%</p> </td> <td> <p>34.56%</p> </td> <td> <p>66.66%</p> </td> <td> <p>0.91</p> </td> </tr> <tr> <td> <p>V</p> </td> <td> <p>71.29</p> </td> <td> <p>12.32</p> </td> <td> <p>4.646</p> </td> <td> <p>60.86%</p> </td> <td> <p>7.88%</p> </td> <td> <p>121.80%</p> </td> <td> <p>0.769</p> </td> </tr> </tbody> </table>

Background on Discover Financial Services

Discover Financial Services was previously a business segment of Morgan Stanley and was spun off shortly before the worst of the 2008 financial crisis.  Carrying consumer loans on its books makes Discover inherently more risky than MasterCard or Visa.  However, industry trends could also turn this potential liability into an asset for the company.  This logic holds true for two reasons: first, the boom in high yield credit has pushed down the net charge-off rate for the company.  In other words, it is cheaper for Discover to finance loans, which may translate into faster than expected net income growth.  Second, non-performing loans have been steadily declining since the credit crisis as consumers have been more scrupulous about their use of debt.  Moving forward, it is expected that fewer write-offs of non-performing loans could translate into better than expected results.

Figure 2: Rebounding Loan Volume and Declining Net Charge-Off Rate 

<img src="/media/images/user_14730/figure-2_2_large.png" />
Another factor contributing to my bullish stance on Discover is relatively low analyst expectations. 2012 has seen a large uptick in the net rate of profitability for the company that is expected to strongly decline, leading analysts to anticipate no net income growth over the next several years.  When a firm that has greatly expanded profitability and analyst expectations are still very subdued, the chances for upside earnings surprises increase.  Looking at the analyst expectations from Standard and Poor's, Discover's run has consistently forced analysts to raise the 12-month target price for the company.  When a low target price is consistently proved to be overly pessimistic it may be a contrarian indicator that anticipates further outperformance when the company jumps over the low bar of analyst expectations. Because the ttm p/e valuation already stands at a lowly 8.6x multiple, any outperformance of these expectations should quickly generate share price appreciation.

Figure 3: Forward Consensus Earnings for Discover Financial Services

<img src="/media/images/user_14730/figure-3_1_large.png" />

A third factor is the global nature of Discover’s footprint.  The company has expanded greatly, with total merchant locations of 20.8 million with 12 million or 58% outside of North America.  Since the trend toward a cashless society is more nascent in emerging markets, this focus is expected to drive profitability over the longer term.  Add to this a shrinking share-count due to repurchases (a $2 billion share repurchase program was announced in March 2012 - equal to 10% of the company's current market cap) and you have an underappreciated, shareholder friendly stock with strong growth prospects.  The company also pays a 1.5% dividend, thus total shareholder remuneration is approximately 6.5% per year.

Figure 4: The Global Footprint of Discover Financial Services 

<img src="/media/images/user_14730/figure-4_1_large.png" />

In total, the future of Discover appears to be very bright.  Even though credit card companies have performed exceptionally well, the valuation does not appear to be stretched.  After very strong share-price appreciation in the past year, Discover has been experiencing a period of consolidation even though the last quarterly report was quite good.  Insiders seem to believe in the future of the company as well, with CEO David Nelms holding 1.97 million shares or a market value of $78 million.  Mr. Nelms gross compensation in 2012 was $9.88 million, thus his holding represents nearly eight years of gross pay, a sizable and concentrated bet on the future of a company that he likely understands better than anyone else. 

Furthermore, while Discover has outperformed the market strongly, the trade does not appear too crowded.  Surveying the recent 13F disclosures for Discover indicates that only nine funds have more than 3% of their portfolio in the stock while twenty-one funds counted it among the top ten holdings.  In many cases, institutional ownership can be a compelling contrarian indicator.  Overinvestment often predates underperformance because once the "big money" is all-in it is difficult to find additional buying power to push the stock higher.

In sum, Discover Financial Services has strong growth prospects, limited institutional ownership, strong insider holdings and a shareholder friendly share repurchase program.  While the share price has entered a period of consolidation, it is expected to regain market outperformance in the not too distant future.  As such, Discover should prove to be a strong addition to the portfolio of a growth oriented investor.

 

 


I am presently short February-$40 puts, which should expire in the money next month to allow me an entry price below $37/share. The Motley Fool recommends American Express and Visa. The Motley Fool owns shares of MasterCard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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