Is Discover the Value Investment in Credit Cards?

Discover Financial Services (NYSE: DFS) is; after PayPal Holdings (NASDAQ: PYPL), my favorite among American fintech companies. I like Discover because it is the only one of the American credit card issuers with a lot of capacity for organic growth.

Companies like American Express (NYSE: AXP) and Citi (NYSE: C) only seem to be able to grow by acquisition, entering new markets or exclusive deals like Citi’s arrangement with Costco Wholesale (NASDAQ: COST). Discover grows the old-fashioned way by adding new customers and new business. In other words organic growth rather than acquisition.

That means it can afford to stay away from potentially high-risk businesses like peer-to-peer or small business lending. It can also keep out of the exclusive card deals that are wrecking Citi’s reputation.

Why You Need Discover in your Portfolio

Beyond that I really like Discover’s financial numbers which make it a true value investment. Here’s what I love about Discover’s financial numbers:

• Growing revenue: Discover reported a TTM revenue of $8.573 billion in June 2015 that grew to $8.739 billion in December 2015 and $8.833 billion in June 2016. During the same period American Express’s revenue fell from $33.62 billion in June 2015 to $32.91 billion in June 2016.

• Growing income: Discover reported a net income of $2.233 billion in June 2015 that increased to $2.303 billion in June 2016. Visa’s (NYSE: V) net income dropped from $6.87 billion in March 2016 to $5.57 billion in June 2016.

 

• Healthy quarterly profit margin: 27.8% in second quarter 2016.

 

• Strong free cash flow: $618 million on June 30, 2016. Note this number has dropped recently it rose to $1.112 billion in March 2016.

 

• Lots of cash: $11.67 billion in and short-term investments on June 30, 2016. That represented an increase of $1.07 billion over June 2015, when Discover had $10.6 billion in the bank.

 

• Healthy cash from operations: $4.007 billion on June 30, 2016.

 

• Actually making cash from financing; $438 million on June 30, 2016. Note this number is down significantly from June 2015 when Discover made $3.538 billion in cash form financing.

• Growing Assets of $87.51 billion on June 30, 2016; up from $84.91 billion in June 2015.

 

• Decent dividend yield of 1.97% on August 8, 2016. A nice increase over the 1.9% from August 4, 2015.

 

• A return on equity of 21.42% for August 8, 2016.

 

All this means that people who were lucky enough to own Discover made some money. My take is that this stock is undervalued at the $57.95 a share it was trading at on August 8, 2016. It’s out performing other credit card stocks for example Capital One Financial (NYSE: COF) which delivered a return on equity of 8.4% on June 30, 2016. It also outperformed Visa which had a return on equity of 19.32% on the same day.

What’s more important is that Discover delivered a return on equity nearly equal to American Express’s 26.61% without the risks. Unlike Amex, Discover is poised to deliver at least some long term growth. At a lower price than Visa or MasterCard (NYSE: MA), making it something of a bargain.

Visa and MasterCard are overpriced

My take is that both Visa and MasterCard are overpriced; and headed for a fall, but Discover is not. Visa in particular is on shaky ground because its booming revenue is not translating into net income.

Expect Visa to drop to a share price $60 or below sometime this year. MasterCard will probably drop but I don’t think it will go below $70. Amex is definitely overpriced at $65.82 and might fall below $50 at some point this year.

What this means is that Discover is the only credit card brand poised to retain its value. If you are looking for a credit card stock that will retain its value, Discover is a great choice. It has potential for growth and value retention that’s more than you can say for the other credit card brands.