Being Fourth Doesn't Work

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

Sometimes being the best at something isn't enough. Discover Financial (NYSE: DFS) is arguably the most recognized rewards credit card. The company's straightforward cash back program is well-known and several of their competitors have created cash back programs to compete. The problem that Discover is running into is it operates a relatively closed system, and its recent earnings show that this system isn't working to its advantage. The company might have the most recognized rewards program, but in the credit card industry it is running in fourth place.

How Do These Companies Compete?

The payment industry is undergoing drastic changes, thanks to new entrants like the privately held Square and eBay's (NASDAQ: EBAY) PayPal unit making inroads where only Visa (NYSE: V) and MasterCard (NYSE: MA) used to tread. The two largest credit card issuers are still the most widely accepted, and this creates a challenge for the smaller players. You know things are difficult when a company like American Express, with all of its brand name punch, isn't even in the same ballpark as Visa or MasterCard.

To be fair, while Square and PayPal are making inroads where other payment services already reside, they aren't real competitors to the credit card issuers. Square is actually backed by Visa and the company serves as a conduit to allow merchants to accept payments. This is really not different than any other merchant service provider, and Square is still primarily reliant on the major payment networks to run its business.

PayPal is essentially in the same boat. PayPal co-brands with MasterCard and though customers could in theory pay with funds in their PayPal account, the company also acts as a conduit for the major credit card processors. Just as an example, it's as easy to pay with PayPal and have the amount charged to your Discover card as it is to pay with funds in your PayPal account. The real battle is being fought between the big four processors.

Visa And MasterCard Versus Everyone Else:

The biggest difference between Discover and American Express versus Visa and MasterCard is both the cost to the merchant and their willingness to co-brand. As any merchant services salesperson will tell you, businesses get a lower rate accepting Visa or MasterCard than they do accepting Discover or American Express. This creates a case where businesses feel like they have to take Visa and MasterCard, but they may not offer the other two.

The co-branding issue can't be understated. Nearly every major financial institution offers a co-branded debit and credit card. Do you know which two companies almost everyone uses? That's right, either Visa or MasterCard. This is partially due to the fact that Discover and American Express prefer to keep their cardholder relationships close to the vest. They don't want their name on a whole bunch of different cards, but this also leads to acceptance in fewer places and a continuation of the struggle to compete against Visa and MasterCard. You can clearly see these challenges in Discover's recent earnings.

Discover's Earnings

Discover reported revenue up 10%, but EPS only increased 2.54%. The company basically does two things: processes payments and makes loans. On the lending side, credit card loans were up 4%, but overall loans increased 9%. This increase is attributable to the fact that Discover makes personal loans and student loans as well. In fact, Discover's student lending business showed an increase of nearly 21%.

Where we can see the company's closed system hurting results is in its transaction volume. On the credit card side of the house payment, volume increased just 4%. When you consider that Visa showed transaction growth of 6% and MasterCard showed volume growth of 18%, you can see that Discover just isn't growing at the same level of these two dominant players.

Discover's Payment Services division did much better, but is unfortunately a much smaller part of the pie. Payment Services volume increased 13% and income in this division grew 31%. If there is a positive to Discover being pickier about who gets a card, it's shown by the fact that the company's over 90-day delinquency rate is just 0.81%.

Conclusion:

Unfortunately for Discover investors, the choice of investment is just as clear as the choice between Discover or Visa and MasterCard at a small business. Both Visa and MasterCard are expected to see 19% earnings growth versus just over 10% growth at Discover. Discover is certainly cheaper at about 9 times forward estimates, but given the choice I'll take the faster-growing yet more-expensive stock every time. The reason is simple, over time a company growing earnings at 19% will cause its P/E multiple to compress much more quickly than a company growing at 10%.

While Visa and MasterCard might look more expensive right now, on a relative basis they are valued nearly the same as Discover. With better growth and better acceptance at Visa and MasterCard, this leaves American Express and Discover trying to play catch up. Since American Express has the much more established brand, in my opinion Discover needs to make some changes. The company must consider opening up its system and reaching out to financial institutions to attempt to co-brand more cards. Where things stand right now, the company is falling behind and being in fourth place just doesn't appear to be working.


MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of MasterCard. Motley Fool newsletter services recommend eBay and Visa. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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