Discover Financial Services (DFS)

[chmcnfunds]

Discover: Sell-Off Presents Buying Opportunity With 40% Upside
Feb. 2, 2015 7:58 PM ET | 6 comments | About: Discover Financial Services (DFS), Includes: MA, V
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
Summary

Since the company posted Q4 2014 results, shares of Discover Financial Services have fallen almost 20%.
Discover presents a unique business model and value proposition, which management has capitalized on.
Despite a weak quarter, Discover presents several short- and long-term catalysts that will add value.
At less than 8x FCF, 10x forward P/E, and a PEG < 1.2, Discover is undervalued by ~40%.
Use this sell-off as an opportunity to pick up shares of Discover at a significant discount.
Company Overview

Discover Financial Services (NYSE:DFS) originated as the Discover Card through Sears in the 1980s. Since then, Dean Witter merged with Morgan Stanley (NYSE:MS), and the Discover segment was spun off in 2007.

Discover operates in two segments - Direct Banking and Payment Services. The Direct Banking segment brings in the vast majority of revenues, and consists of credit cards, loans (student, personal home, home equity), prepaid cards, and bank accounts (CDs, Money Market, Checking, Savings). The Payment Services segment contains the ATM/debit network PULSE, as well as Diner's Club and Discover's network partners.

Although the majority of revenues stem from Discover's credit cards, the company is different from both Visa (NYSE:V) and MasterCard (NYSE:MA) in that while both the latter's business models are to act as a financial intermediary between consumers and a network of banks (open-loop), Discover is its own bank (closed-loop). This allows it to capitalize on lower costs through both the lack of branch networks and lower credit card loss rates.

David Nelms has been CEO since 2004, and served as president and COO prior to taking up the CEO position. During the past 11 years, Nelms has done an excellent job managing the company, as evidenced by its stable navigation through the financial crisis and consistent above-average growth after it. Nelms owns a significant portion of stock, and two-thirds of his compensation is tied to share performance.

Moat/Competitive Advantages

In addition to the closed-loop structure, Discover is differentiated from a strategic standpoint in that while banks look to secure cards for those with existing bank accounts, Discover looks to secure bank accounts for those with cards. In a time when the financial services sector has resorted to simply buying customers from other companies in order to grow, Discover has achieved and will continue to achieve organic growth through the customer. Discover looks to take the credit card user, transition them into a user of its financial services, and finally become the customer's home bank. As the industry leader in customer service and customer loyalty, it's not hard for Discover to not only make this transition, but also generate new customers year after year.

The simplicity of the network effect is crucial to Discover's success. As more consumers become customers of Discover, merchants are incentivized to become members of the payment network. On the other hand, as more merchants become a part of the network, consumers are incentivized to become cardholders. Thus, each marginal user both on the customer and merchant side of the transaction benefits from the marginal user on the other side. Although Discover's payment network is relatively small compared to the open-loop giants of Visa and MasterCard, it is growing and should continue to provide additional value for users on both sides of the transaction, while generating additional revenue for Discover.

Although credit standards have fallen in recent years, like American Express (NYSE:AXP), Discover has always focused on the prime borrower. The company's commitment to disciplined credit risk allows it to maintain modest write-offs and keep a low cost of funds. Additionally, this focus on the prime borrower allows it to hold on tighter to the customer compared to Visa and MasterCard in a downward turning credit cycle.

Competitors

Discover is involved in the credit card, banking, and payment services businesses, which means it not only competes with Visa and MasterCard, but also with banks and other credit providers, such as Capital One (NYSE:COF), American Express, Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Citibank (NYSE:C), and Wells Fargo (NYSE:WFC). Selected data are shown in the table below:

(click to enlarge)(click link below for tables/charts)


(Source: Data via FinViz, author analysis)

Discover holds 6% of the market share of card issuers, and is #6 in sales volume behind American Express, Chase, BAC, Citi, and Capital One. In Network Purchase Volume, Discover ranks 5th, at just 5%. Discover has 62M cards in circulation, representing 10.7% of the total across the 4 major players. It is the 3rd-largest card by number of cards in use, and the 4th-largest in card balances.

Most Recent Quarter

In Q4 of 2014, Discover posted lackluster earnings results. After accounting for one-time charges, EPS came in at $1.19 versus Wall Street's estimate of $1.30. Last year, Discover beat EPS estimates of $1.18, coming in at $1.24. Revenue came in at $2.037B versus $1.811B, and net income decreased to $404M from $602M one year prior. One major reason was for the earnings miss was an increase in provisions for loan-loss reserves to $457M versus $354M a year earlier. Additionally, expenses grew 10% versus 6.3% loan growth. Management also expressed their disappointment with the lack of success in mortgages, evidenced by a $27M write-down of goodwill. Although progress in this segment would have certainly been good to see, the lack of progress was more than reflected in the drop in share price, and I believe was more a function of the state of the mortgage market and Discover's relatively new entry into it. Discover took somewhat of a contrarian stance; as others were leaving the market, it entered. Like many contrarian actions, this may not see immediate results, but I believe it will show to be a highly profitable move in the long run.

Shares have fallen 18% since their 52-week high late in 2014, and 9% since the earnings release on January 21. Management provided light guidance for 2015, highlighting revenue margin, provision for loan losses rate, and operating expenses. Due to increases in the latter, we can expect the net income margins to compress slightly in 2015. Overall, management's words and tone remained optimistic throughout the call in regards to 2015.

CFO Mark Graf Spoke to the provision for charge-offs:

Number one, I would say is I think we really hit the bottom for this cycle, I would say with respect to credit this last year ... And then on top of that, you look at three years of consistent loan growth that we've put up, whereas most of our peers have returned to loan growth really only like the last six months... So I think it's just an inevitability of the fact we've been growing. It doesn't feel like there is a problem. It doesn't feel like there is a fundamental turn in credit. It's just a function of growth.

On the call, CEO David Nelms also alluded to a new product launch coming from the Discover It platform coming rather soon.

I don't want to preempt the launch. I would just say we'll have the details out very soon. The one thing I would say is that we do think our Discover It platform is something that can be leveraged into other products that have some of the advantages that Discover It offers including free FICOs and pricing features, lots of features that others don't have, but maybe something a little different than our traditional cash back bonus program. So stay tuned, we'll give you the details real soon.

Valuation

Due to its closed-loop operational structure, Discover has higher margins than other credit service providers, which contributes to a consistent ROE of over 20%, despite a relatively low Price-to-Book. As was shown in the table above, Discover has the second-highest ratio of ROE to Price-to-Book among the top 5 credit card providers. It also boasts a 14.50% Free Cash Flow yield, trading at 7.7x FCF, handily beating out its peers and the credit services industry. Currently valued at a trailing P/E of 11.12 and a forward P/E of 9.53, Discover appears undervalued. A PEG ratio of 1.18 is the lowest in its peer group, and confirms the same.

In a simple DCF model constructed, free cash flow grows at an annual rate of 4.50% through 2019. Using a discount rate of 10% and a perpetuity growth rate of 2.5%, the fair value of the company is estimated to be ~$34B. With 449M shares outstanding, this yields a fair value of ~$76 per share, representing ~40% upside from Friday's close. Even when employing the most conservative estimates of DCF inputs, a substantial discount still remains.

Risks & Catalysts

A primary risk to investing in Discover is the rapid evolution of the payments industry, especially in mobile payments. Bitcoin's popularity even leading to ETFs, PayPal's spin-off from eBay (NASDAQ:EBAY), Apple (NASDAQ:AAPL) Pay, Peer-to-Peer lending, and other entrants to the market show the desire for change, and each of these marginal entrants look to revolutionize the industry and gain market share, which could encroach into existing credit services. While Visa and MasterCard have partnered with Apple, Discover has had trouble driving volume. Although its payment network is a small contributor to revenue and net income, Discover has already partnered with firms like Ariba, China UnionPay, and PayPal. If this network can reach a fuller utilization, Discover will benefit immensely. The company also has the opportunity to partner with these marginal entrants to the mobile payments market and expand its reach through them.

A downturn in the credit cycle will hurt Discover through a decrease in volume. There are, however, some advantages Discover has that will allow it to outperform peers, despite a downturn in the credit cycle: its closed-loop system, disciplined credit risk, and the inherent growth that will occur in net income margins. The second macro factor we're seeing is the impact of lower gas prices. As opposed to what many hypothesized, the fall in gas prices has not seen a large impact on consumer spending. The WSJ reported that consumers are not increasing discretionary spending, rather they're saving their money or paying down debt. Regardless of interest rates or oil prices, the value investor should not be concerned with short-term macro fluctuations except to the extent that they damage the long-term health of the business. Buffett once stated, "If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes." Discover is one such stock that will succeed in both a healthy and a weak macro environment.

Given Discover's large and consistent cash flow, it has numerous opportunities to add to shareholder value. To generate future growth, it could expand into international territory and foster greater acceptance of the Discover card domestically. Discover offers a unique value proposition and has the earnings and cash flow to prove it, but management has yet to bring this internationally, and the company's domestic reach is limited, as evidenced by its market share compared to giants Visa and MasterCard. New initiatives could be put in place using this cash that would add to shareholder value not only in the immediate term but in the long term. Additionally, cash allows management to buy back stock. Shares of Discover trade at only 7.7x FCF and under 10x forward earnings. Relative to both peers, the industry, and the market as a whole, Discover is substantially undervalued. Management has indicated this in the past by their dedication to retiring shares, bringing the total count from 549M in 2010 to 449M in the most recent quarter. Discover also offers a 1.75% dividend, which also could be increased. Regardless of Nelms' decision of where to allocate this free cash flow, investors should have confidence given his track record.

As alluded to in the Q4 2014 call, Discover is looking to launch a new product soon, based on the existing Discover It platform. The increase in marketing expenses incurred in the most recent quarter reflected the coming of this launch, and is part of what contributed to the earnings miss. Although management hasn't provided much information as to what this new product entails, investors should be confident that it will add value to the company.

Summary

(click to enlarge)(click link below for tables/charts)

Shares of DFS faltered in late 2014 before the Q4 2014 results came in on January 21, 2015. Since releasing both Q4 2014 results and issuing 2015 guidance, shares have fallen an additional 9%. Although the Q4 results were demonstrative of short-term issues, both short- and long-term catalysts remain. I'm paraphrasing, but Seth Klarman once said, "If you buy a stock at $50 and it's worth $100, you're not worried if it goes to $40." I see Discover Financial Services as one such stock. Although currently dropping in value, Discover is worth much more than it trades at today. The most recent earnings report triggered an overreacting market, with analysts dropping price targets and investors panicking. This irrationality has presented investors with a rare buying opportunity to pick up shares of Discover at a significant discount to their intrinsic value.
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