Market Mad House

In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule. Friedrich Nietzsche

Long Ideas

Is Discover Financial Making Money?

The two giant global payment-card brands: Visa (NYSE: V) and MasterCard (NYSE: MA) have been growing like weeds in the past few years. That made me wonder about the other U.S. credit-card brand a lot of people forget about Discover Financial (NYSE: DFS).

For those of you unfamiliar with it, Discover Financial Services is an independent credit-card brand confined to the United States. It started life as a subsidiary of Sears; that went through a number of owners before becoming an independent company in 2007.

Currently, Discover is the sixth-largest credit card issuer in the United States with a 6.94% market share; and around 38.7 million members in June 2017, according to Value Penguin. Discover also had $61.37 billion in outstanding credit-card loans in fourth quarter 2017 according to SEC filings.

Discover also owns Diner’s Club; the oldest US credit-card brand which is accepted in 185 countries. Other holdings include Pulse, a network of automatic teller machines (ATMs) and cash registers that serves 4,500 banks, credit unions, and other financial institutions across the United States.

Is Discover Financial Making Money?

With all those resources, most people would assume that Discover is making money and they are right.

Discover reported a net income of $2.275 billion on 30 September 2017. The number is good; but down from the $2.33 billion net income that Discover reported in September 2016. The company’s income is falling even though its business is growing.

Discover reported $9.641 billion in revenues in September 2017, up from $9.946 billion in September 2016. Those revenues have been growing steadily for some time; they were $8.571 billion in September 2015. The problem is that the net income indicates Discover is making less money from those revenues.

Discover Financial is generating a Lot More Cash

Although it is generating more cash, Discover reported a free cash flow of $1.494 billion on September 30, 2017. That was up from $1.271 billion in September 2016 and $1.116 billion in September 2015.

More importantly, cash from operations has grown dramatically at Discover. The company reported $4.876 billion in September 2017, up from $4.177 billion in September 2016. It also managed to make a lot of money from financing $4.276 billion in September 2017.

Cash from financing has shown even more growth at Discover, it rose from $3.332 billion in September 2016 to $4.276 billion in September 2017. That indicates Discover is generating more cash from all those credit cards.

Discover Financial is a Value Investment

This cash is adding a lot of value to Discover in the form of $13.25 billion in cash and short-term investments on 30 September 2017. This was a slight increase over $12.93 billion in cash and short-term investments on 30 September 2016

Beyond that, Discover had assets of $97.61 billion on September 30, 2017, up from $90.54 billion in September 2016. It also achieved an enterprise value of $37.85 billion on 22 November 22, 2017.

So yes folks Discover Financial Services is a value investment because it has a lot of cash. More importantly, Discover is cheap it was trading at $65.40 a share on 22 November 2017. The company is also dramatically undervalued; DFS had a market capitalization of $23.77 billion despite an enterprise value of $37.85 billion on the same day.

Discover shareholders enjoyed a dividend of 35¢ on 21 November 2017. That dividend grew by 5¢ over the course of the past year. Discover paid a 30¢ dividend in November 2016.

Best of all Discover shareholders were rewarded with a return on equity of 21.23% on September 30, 2017. These numbers demonstrate that Discover Financial is a very good stock that the market is ignoring right now.

Discover Financial Services has a lot of Growth Potential

Discover has a lot of growth potential because it is a smaller credit-card issuer.

Value Penguin estimated that the number of active credit-card accounts at smaller issuers grew by 66% between 2011 and 2016. During the same period, the number of active accounts at the two largest US credit card issuers Citi Group (NYSE: C) and JPMorgan Chase (NYSE: JPM) grew by just 3%.

The most likely reason for the dramatic growth at smaller issuers is the hatred and distrust for the monster banks (Chase, Wells Fargo and Bank of America) among large segments of the American population. Many Americans distrust those banks and their products because of scandals and the financial crisis.

If you’re looking for a good basic financial stock to add to your portfolio Discover is certainly worth a look. It’s a great value investment with a low price, a lot of cash, and a lot of growth potential.