Visa (V, Financial) or MasterCard (MA, Financial)? When I hear questions about investing in credit card companies, those are often the only two names that come up. Yet, as we know, several other strong companies exist in that space.
In this article, we look at Discover Financial Services (DFS, Financial), a smaller but nonetheless strong competitor in this field. Its businesses include the Discover and Diners Club cards as well as several ancillary businesses.
After recent price declines, it now has a prominent place on the Buffett-Munger screener. With a PEG valuation (P/E divided by five-year EBITDA Growth) of just 0.44 it warrants consideration by value investors – that is, investors who can live with some long-term debt. Other than that, Discover has much to recommend it, including a 5-Star predictability rating and a strong five-year EBITDA growth rate:
History
1985: Sears and its subsidiary, Dean Witter Financial Services Group Inc., introduce the Discover card at a Sears (SHLD, Financial) store in Atlanta; a national rollout follows.
In 1995, name changed to NOVUS Services Inc., distinguishing the company's network functions from the Discover card.
1995: Dean Witter (including the Discover/NOVUS unit) merges with Morgan Stanley (MS, Financial).
1999: Name changed to Discover Financial Services Inc.
2007: Discover unit is spun out of Morgan Stanley and begins trading on the NYSE as DFS.
2005: Discover buys the PULSE payments network, which has more than 4,000 member banks and 4 million merchant and cash access locations.
2005: A strategic alliance with China UnionPay begins, allowing reciprocal card acceptance.
2006: Finishes buying Goldfish, a major reward card issuer in the United Kingdom.
2006: Becomes the first credit card services company to take on Visa and MasterCard in the signature debit market.
2008: Acquires Diners Club International.
2009: Introduces the Discover app for iPhone and iPod Touch users.
2010: Buys The Student Loan Corporation.
2012: Buys the Home Loan Center and goes into the mortgage business.
2015: Closes Discover Home Loans (the business acquired in 2012).
History based on information at the company’s website and Wikipedia.
Comments: Discover Financial Services is a roughly 30-year-old company that has grown through domestic and global acquisitions, strategic alliances and internal growth.
Discover Financial's businesses
Discover calls itself a direct banking and payment services company through subsidiaries. Unless otherwise noted, information here comes from the company’s 10-K for 2015.
Direct banking
This includes consumer banking and lending products:
- Discover branded credit cards issued to individuals.
- Other consumer banking and products services, including credit card loans, private student loans, personal loans, home equity loans and deposit products.
Payment services
In this category, the company operates the Discover Network, PULSE Network and Diners Club International.
- Discover Network processes transactions for Discover-branded credit cards, as well as payment transaction processing and settlement services.
- PULSE Network operates an electronic funds transfer network providing access to ATMs domestically and point-of-sale (POS) terminals are provided at retail locations in the U.S.
- Diners Club International is a global payment network of licensees, usually financial institutions, that issue Diners Club branded cards and/or offer card acceptable services. Most of the royalties and revenues from Diners Club originate beyond the U.S.
Sources of revenue
Discover offers a diversified bundle of revenue sources, as shown in a presentation at the 2016 Barclays Americas Select Franchise Conference (May 17):
While diversified, note that 97% of the company’s pretax revenue comes from direct banking and 3% from Payment Services.
Within that context, most of direct banking’s revenue comes from its credit card business, as this excerpt from the 10-K for 2015 shows:
Competitors
As we would expect from a credit card company, it faces competition from the big three:
In addition, it competes with PayPal (PYPL, Financial), Capital One (COF, Financial) and Synchrony Financial (SYF, Financial), formerly GE Capital Retail Finance Corporation. According to GuruFocus.com, all six companies have greater capitalizations than Discover.
Growth
GuruFocus reports, “Discover Financial Services has shown predictable revenue and earnings growth,” and over the past five years, revenue per share has grown by an average of 11% per year.
The company says (in its Barclay’s presentation) that innovation and brand strength have been the main drivers of its growth:
Looking forward more broadly, the company spells out its 2016 focus this way:
Yahoo! (YHOO, Financial) Finance shows 23 analysts following Discover, and their low target is $56, which is just above its close on June 13. The high target comes in at $75 while the mean and median are $63.17 and $63.
Other
Incorporated in Delaware, Discover is headquartered in Riverwoods, Illinois.
David W. Nelms, age 55, is the chairman and chief executive officer. Before joining Discover in 1998, he was vice chairman of MBNA America Bank.
It had a workforce of 15,036 as of Jan. 31.
Comments: Discover Financial is a somewhat diversified company but depends very heavily on its credit card portfolio. At the same time, the company has done well leveraging its credit card data into other banking areas. It faces a half-dozen major competitors, but after 30 years arguably is well positioned to withstand competition. The company has a growth strategy that should allow it grow respectably.
Ownership
Eleven of the gurus followed by GuruFocus have holdings in Discover; the three largest are Barrow, Hanley, Mewhinney & Strauss, PRIMECAP Management and NWQ Managers.
Eighty-eight percent of outstanding shares belong to institutional investors while shorts have 1.55% and insiders own 1.37%.
Comments: Large institutional holdings and a strong showing by the gurus, as well as low short holdings, suggest the market has confidence in Discover Financial.
Discover by the numbers
Comments: Before its recent tumble, Discover was nearing its 52-week high. It has a P/E of 10.25, an ROE of more than 20%, a dividend of close to $2, and it bought back more than 6% of its shares last year.
Financial strength
As the GuruFocus automated system shows, Discover Financial earns a middling score for financial strength and a strong score for growth and productivity:
Why the weakness on the financial strength score? For an answer, let’s turn to the Severe Warning Sign, which says, “Discover Financial Services keeps issuing new debt. Over the past three years, it issued U.S. $5.1 billion of debt.”
Looking at a chart of long-term debt, we see it jumped about five years ago, and since then the level has grown but at a slower rate:
GuruFocus also provides this competitive comparison, which shows Discover's interest coverage on a par with its peers Synchrony and Capital One:
Comments: As the Growth & Profitability section above indicates, revenue, EBITDA and EPS are all growing. Debt also has grown, but the pace of borrowing has slowed in the past few years.
Valuation
Discover Financial has places on both the Undervalued Predictable and Buffett-Munger screeners. With a more than 4% drop in its share price on June 14, DFS found itself holding the dubious distinction of being first on the Buffett-Munger screener. The company’s PEG ratio (Price/Earnings divided by the five-year EBITDA growth rate) stood at just 0.44.
Generally, stocks with a ratio of less than 1 are considered under-valued, stocks between 1 and 2 are considered fair-valued, and those above 2 to be overvalued.
As for the Buffett-Munger criteria, GuruFocus outlines them this way:
- “Companies that have high Predictability Rank, that is, companies that can consistently grow its revenue and earnings.
- “Companies that have competitive advantages. It can maintain or even expand its profit margin while growing its business.
- “Companies that incur little debt while growing business.
- “Companies that are fair valued or under-valued. We use PEPG as indicator. PEPG is the P/E ratio divided by the average growth rate of EBITDA over the past five years.”
We see that No. 3 might be a bit contentious, but otherwise, Discover fits well. In particular, it has a predictability score of 5, which is very good. Note that PEG and PEPG are the same measures.
How does Discover compare with its competitors on valuation metrics? The following table shows results for P/E, PEG and Predictability:
P/E ratios, two clusters: on the low side, Discover, American Express, Capital One and Synchrony; on the high side, Visa, MasterCard and PayPal.
PEG ratios: Only one of this group found in the undervalued category, which is, of course, Discover. All the others fit in the fair-valued category.
Predictability: Again, Discover is likely in a class by itself, (ratings are not available for three of the six).
One other issue here: dividends. At closing on June 14, after several of the six had suffered significant drops in their share prices, Discover had the second-highest dividend yield, at 1.91%, just ahead of American Express and well ahead of Visa and MasterCard. Capital One had a dividend of 2.43%.
Comments: Based on P/E, and especially PEG, Discover looks attractive. It has not only the highest predictability rating but also the lowest PEG and the second-highest dividend.
Conclusion
As an investor, it’s hard not to like Visa and MasterCard with their consistent growth year after year. But with P/E ratios over 25 investors looking for value might want to consider Discover Financial Services instead. The only caveat might be its long-term debt.
Its strong EBITDA growth should lead to capital gains somewhere in the future. In the meantime, you can harvest a dividend yield of around 2%, based on the current prices.
If the company continues to buy back shares at a similar rate as that of the past four years, the buy back plus dividend gives you a 7% to 8% return before capital gains. That sounds like a good foundation for a long-term hold.
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