Discover Trading at Lower Multiples Than Visa, MasterCard, Amex Despite Topping 4Q Earnings Expectations

Discover Financial Services (DFS) should be a stock that catches the eyes of traders and investors. Crowned as the top performer this year in the Standard & Poor's 500 Financials Index, the company closed Wednesday's session at $23.82, up about 30 percent since the start of 2011. However, Discover is trading at a lower multiple compared with its peers, Visa Inc. (V), MasterCard Inc. (MA) and American Express Co. (AXP), despite strong profitability.

Discover's Profit Leaps 46 Percent in the Fourth Quarter

Discover Financial Services (DFS) Thursday reported a 46 percent jump in net income for the fourth quarter that blew past Wall Street estimates, helped by the holiday shopping spree and falling default rate.

The Riverwoods, Ill.-based credit card company said net income for the quarter ended Nov. 30, 2011 was $513 million, or 95 cents per diluted share, as compared with $350 million, or 64 cents per share for the same year-ago period. Analysts surveyed by Thomson Reuters called for earnings of 92 cents a share.

The company also announced it repurchased 9.6 million shares in the fourth quarter for $227 million, bringing the total shares repurchased for the program to 18.0 million or $425 million. The drop in the number of shares outstanding also gave the per-share results a boost.

Also on Thursday, Discovery's board declared a cash dividend of 1 cent per share of common stock, payable on Jan. 19, 2012, to stockholders of record at the close of business on Dec. 29, 2011.

Main services for Discover are credit cards, personal banking, and student loans.

In the fourth quarter, total loans grew 17 percent from the prior year to a record $57.3 billion. The company purchased an additional $2.4 billion in private student loans in the fourth quarter.

Credit card loans grew 3 percent from the prior year to $46.6 billion and Discover card sales volume was up 8 percent to $25 billion.

Revenue rose 13 percent to $1.81 billion, from $1.6 billion last year.

Better customer payment habit and improved economic condition led to a continuous decline in late payments and defaults. The delinquency rate for credit card loans over 30 days past due dropped to 2.39 percent, compared with a 4.06 percent delinquency rate in the same quarter a year earlier. Meanwhile, credit card net charge-off rate declined to 3.24 percent, from 6.95 percent in the fourth quarter of 2010.

As a result, the drop in uncollectable fees enabled Discover to release more of its reserve fund set aside to cover unpaid balances.

Why Is Discover Trading on Multiples Lower than Its Competitors?

However, investors may not expect the stock to see continued robust growth. Despite the company's fourth-quarter's strong performance, investors are cautious about what may come in the longer term.

The company's shares are trading at lower multiple than its peers' in part because Discover is using its reserves to boost its bottom line, which suggests that part of the company's profit recorded was not derived from organic growth, but from reaching into an existing and finite pool of money that had been set aside to cushion against loss.

Discover has been releasing reserves for six quarters -- making this the seventh straight quarter -- and the size of the pool is diminishing. The firm had $2.07 billion in reserve against loan loss at the end of the fourth quarter, compared with $3.21 billion in the same period in 2010.

"The challenge for Discover is really not the current quarter," David Darst, analyst at Guggenheim Partners LLC told the International Business Times. "The challenge for them is that, as they move into next year, it's going to be more difficult for them to have earnings growth because of the magnitude of reserve release they had in 2011."

Another challenge for Discover and its peers will be growing their card portfolio, Darst told IBTimes.

Card companies have been reporting an increase in customers using cards and paying their balances off in the same month, which means their balances don't rise. That's good for the customers, but it limits a card issuer's gains from charging interest.

"This makes it harder for Discover to grow its asset base," Darst said.

Assessing Discover Segment by Segment

Student loans -- Discover's student loans services focus on higher education, a niche that has a more reliable profile and results in lower losses relative to some of the government related programs. The student loan business has been picking up with more people heading back to school and the increase in the cost of college.

Credit card portfolio -- Darst said Discover has a very loyal card base and the company has been successful in growing new card holders, as well as card acceptance, which is an important trend for the firm to continue to expand.

Direct banking -- The direct personal banking model differentiates Discover from other banks. The company has been executing and growing a business model desired by customers at a time when more people feel there's no need to go to physical bank branches, according to Darst.

Let's Look At the Numbers

An investor sentiment indicator -- the price-to-earnings ratio -- shows what investors think the company is worth. Discover's P/E ratio of 6.18 puts it lower than the historic P/E ratio of the median stock in the S&P 500 Index, which is about 15.

Darst has a neutral rating for Discover and assigns a one-year target price of $26.

"Discover's earnings stream is more heavily driven by the net interest income, relative to American Express, Visa and MasterCard, which have much higher fee income," Darst said, explaining why Discover has historically been trading at a relatively lower multiple.

According to a research note from Guggenheim, Discover receives 31 percent of its revenue from fee income while MasterCard and Visa receives 85 percent of their revenues from fee income. Therefore, Darst expects Discover to maintain a more bank-like valuation, but he believes the credit card company should trade for a premium to banks given its profitability, lower credit risk profile, and higher expected growth rate.

"Relative to the banks, Discover's balance sheet and earnings stream are less diversified. So even though it has a higher profitability level than most banks, it is trading at a lower price to earnings multiple," he added.

Over time, Darst do expect the situation to change as Discover begin to add more asset classes to the balance sheet, which should in turn result in the company getting a higher multiple while it continues to generate strong returns and buy back stocks.