Discover Financial Services (DFS)

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How American Express’s Costco loss makes Discover look better

Amex is taking a hit, highlighting the safer and better-performing Discover

By
PHILIP
VAN DOORN
INVESTING COLUMNIST

American Express has been the most profitable big U.S. bank for many years. But the credit-card company’s stock implosion on Thursday underlines two risks and puts a spotlight on Discover Financial Services.

American Express Co. AXP, -6.70% said Thursday that its exclusive contract with Costco Wholesale Corp. COST, -0.14% will end on March 31, 2016. That’s right: If you shop at Costco, the only credit cards you can use are the co-branded TrueEarnings card or an American Express card.

But American Express has decided it no longer wants to “pay to play,” with CEO Kenneth Chenault saying in a statement: “We were unable to reach terms that would have made economic sense for our company and shareholders.”

Shares of American Express were down as much as 7% on Thursday, wiping $6.2 billion off its market value.

During a conference call on Thursday, Chenault said: “More than 70% of the purchase volume from cards that we issue takes place on non-co-branded products.” That means nearly 30% of the company’s transaction volume comes from co-branded products, underscoring the severe blow from the loss of Costco. The CEO said American Express will be going after new co-branding deals, since “a number of major partnerships that are not currently with American Express will be coming up or renewal during the next few years.”

‘The Costco U.S. co-brand portfolio makes up about 20% of worldwide loans and about 10% of worldwide cards in force.’
Jeffrey Campbell, American Express
So there’s hope that, over the next few years, American Express will be able to limit the damage.

Still, American Express expects a “significant impact” from the loss of the partnership on sales and earnings for 2015 and 2016. “The Costco U.S. co-brand portfolio makes up about 20% of worldwide loans and about 10% of worldwide cards in force,” according to CFO Jeffrey Campbell.

Chenault expressed confidence that, after 2016, American Express could return to increasing its annual earnings per share by 12% to 15%.

A very strong long-term track record with a high valuation
Among the 30 largest U.S. banks by total assets, American Express has had the strongest annual returns on common equity over the past four years, ranging from 23.53% to 28.84% (in 2014), according to FactSet. For the four years, Amex’s average ROCE has been 26.92%. The stock closed at $86.01 Tuesday and traded for 13.1 times the consensus 2016 EPS estimate of $6.58. Of course, depending on the action for the stock, the forward P/E may climb, as analysts lower their earnings estimates over coming days.

Discover Financial Services DFS, +1.09% provides an interesting contrast to American Express. It is a much smaller company and lacks the co-branding relationships enjoyed by Amex. Discover’s return on common equity has ranged from 24.20% (in 2014, according to Oppenheimer) to 29.96%, for an average of 26.38%, ranking a close second to Amex. And its stock trades for only 10.3 times the consensus 2016 EPS estimate.

U.S. Bancorp USB, +1.51% ranks third among the 30 biggest U.S. banks, with a four-year average annual ROCE of 15.94%, according to FactSet, which is an impressive number for a bank that doesn’t focus on credit-card lending.

Getting back to the two credit-card lenders, both have served their shareholders well, with growth and stock buybacks, which reduce share count and boost earnings per share. But Discover has been, by far, the better performer.

The five-year total return, with dividends reinvested, for Discover’s stock through Wednesday was 377%, the best performance among the top 30 U.S. banks. That compares with a 113% return for the S&P 500 Index. Among big banks, American Express was tied with Huntington Bancshares Inc. HBAN, +1.43% for second place, with a five-year return of 141%.

For three years, Discover’s total return is 117%, once again ahead of its rivals and the 64% return for the S&P 500. Among the 30 largest U.S. banks, American Express ranks 12th, with a total return of 72%.

With a higher valuation, along with what might be two years of negative headlines as year-over-year comparisons show the effect of the nonrenewal of the Costco partnership, American Express looks like a far riskier play than Discover. As a result, you might expect Discover to extend its gap with American Express.
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http://www.marketwatch.com/story/how-american-express-costco-loss-makes-discover-look-better-2015-02-12?mod=mw_share_twitter

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