Discover Value With This Credit Card Company

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

With consumer credit on the rise again, and tangible signs appearing of US economic recovery, things look pretty good for credit card companies. Supplying consumers with day-to-day credit, these companies tend to maintain huge gross margins. Of the four main US credit card providers, one has a considerably lower market cap, and is at the same time trading at a considerably lower valuation than the competition.

Company at a Glance

Discover Financial Services (NYSE: DFS) provides a range of payment and credit services to consumers and small business across the United States. The firm operates in two divisions, Direct Banking and Payment Services. The Direct Banking division offers credit cards, as well as a number of other consumer lending and saving services. The Payment Services division offers an ATM system and a global payment network. The stock has $20.54 billion market cap, and has had a good run of almost 36% in the last twelve months. It has a beta of 0.89 and a 1.4% dividend yield.

Comparative Valuations and Metrics

At first glance, the stock looks like a bargain. With a TTM P/E of only 9.26x, Discover is valued at less than half of MasterCard’s (NYSE: MA) 24.05x and less than a quarter of Visa’s (NYSE: V) 44.8x. The PEG ratio is also low at 0.87, similarly at a discount to the 1.14 industry average. The price to sales of 3.02 paints a similar picture compared to MasterCard’s 8.76 and Visa’s 9.94. Gross margins on the other hand are fairly equal across the board, all between 96% and 100%. Discover maintains a return on equity of about 26% and has a payout ratio on its dividend of only 9%, meaning this could easily go up in the future. Could earnings be the reason for Discover’s undervalued status?

Earnings

Between 2010 and 2012, Discover saw huge EPS growth going from $1.22 in 2010 to $4.46 in 2012. Growth is expected to take a bit of a breather in 2013, with a full-year analyst consensus of about $4.38. In the latest report for Q4 2012, EPS missed by 6 cents, whereas Visa beat in both Q4 2012 and Q1 2013. MasterCard has also had a number of healthy beats throughout 2012. On the other hand, Discover raised dividends by 40% in Q4, and reported fairly healthy organic growth of 6% on total receivables. The Payments segment did rather well with 13% YoY purchase volume growth largely driven by the PULSE system. Net interest income increased 11% over the prior year.

For the full-year, the company returned just over $1.4 billion to shareholders through buybacks and dividends. Looking forward, the three credit card companies are all looking at similar 3-5 year EPS growth rates of between 26% and 30%. Discover’s strong earnings performance and remarkably low valuations have led one analyst to claim the stock should expect upside of between 35% and 40%, recently having upgraded the stock to outperform.

Bottom Line

Having reviewed some of the metrics for Discover as well as its earnings performance, it is still unclear to me why Discover is trading at such a deep discount to its peers. Could it be that the market is simply undervaluing the stock? While it doesn’t have the same size in terms of market cap, the company is still performing well in a challenging environment, and should be able to continue making good money. Moreover, the stock’s low multiples allow for significant upside in the future.


DUJames has no position in any stocks mentioned. The Motley Fool recommends 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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