It May Be Time to Lose Discover Financial Shares

by Will Ashworth | September 6, 2011 2:28 pm

A little more than four years ago, Morgan Stanley (NYSE:MS[1]) spun off Discover Financial Services (NYSE:DFS[2]) into its own independent company. Trading as low as $4.73 in March 2009, it’s been all uphill for Discover since climbing out of the abyss. At just under $24, it now trades close to its opening-day price. The question is whether this momentum continues. Nothing suggests Discover is a bad company. Nonetheless, I’ll look at some reasons why shareholders might want to consider an exit at this point.

Margin of Safety

Discover’s current yield is 1%. Its major competitors, American Express (NYSE:AXP[3]), Visa (NYSE:V[4]) and MasterCard (NYSE:MA[5]), pay 1.5%, 0.7% and 0.2%, respectively. The question you have to ask yourself about both Discover and American Express is whether the extra yield is worth it given their exposure to potential loan losses. Granted, Discover’s charge-off rate in July was 3.83%, its lowest level since October 2007, and credit card late-payments industrywide hit a 17-year low. Americans seem to be using their credit far more sensibly, resulting in lower loan loss provisions and higher profits for both American Express and Discover. However, as we know from experience, consumers have short memories. If unemployment drops at some point in 2012 or 2013, the cash registers will ring fast and furious, and with that comes the increased potential for loan losses. It’s a vicious cycle. Visa and MasterCard, on the other hand, don’t issue credit cards and thus avoid exposure to any losses while benefiting from the increase in transactions.

Valuation

It appears, at first glance, that Discover is a much better buy than either Visa or MasterCard. Its price-to-sales, price-to-book and price-to-earnings ratios are all lower than its two peers are. However, comparing apples to apples, Capital One (NYSE:COF[6]) is cheaper than Discover and its debt-to-revenue ratio is 284%, compared to 356% for Discover. However, what tips the scale in my mind is Capital One’s $9 billion purchase of ING Direct. Opponents of the deal feel this will create another “too-big-to-fail” bank that American taxpayers will have to bail out at some point. What those opponents fail to understand is that online banking can be the key to a stronger enterprise. In Canada, several smaller banks and credit unions are winning business by offering online high-interest-savings-accounts that pay 2% or more. Consumers actually benefit from the additional competition they provide bigger banks like Toronto Dominion (NYSE:TD[7]) and Bank of Montreal (NYSE:BMO[8]). In the end, somebody had to buy ING Direct. Why not Capital One?

Morgan Stanley

Last August, I wrote an article[9] about spinoffs. It was based on a Money Magazine article from 1999 that found offspring tended to outperform their parents in the first 18 months of trading. Between July 2, 2007, and January 2, 2009, Discover’s stock lost 67% compared to a loss of 75% for Morgan Stanley. That’s inconclusive, so I’ve gone one step further and compared the two from January 2009 to today. On this account, it’s not even close. Discover beat Morgan Stanley by 162%. Morgan Stanley investors would have been better off selling their shares in 2007 and buying more Discover stock. Those who did choose to do this and still hold today would have a 15% paper loss instead of a 64% decline. There is, however, a silver lining. Morgan Stanley’s business is actually doing OK, and its stock is at its second lowest point since the 1990s. Discover might hit $30 if you’re lucky, which brings another 25% appreciation. If Morgan Stanley’s profits continue to improve, a 25% increase in its stock price seems a bare minimum. The risk/reward here makes a lot more sense for the parent than the child.

Bottom Line

It will be interesting to see what happens to both stocks in the next four years. My money’s on Morgan Stanley.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

 

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.

Endnotes:

  1. MS: http://studio-5.financialcontent.com/investplace/quote?Symbol=MS
  2. DFS: http://studio-5.financialcontent.com/investplace/quote?Symbol=DFS
  3. AXP: http://studio-5.financialcontent.com/investplace/quote?Symbol=AXP
  4. V: http://studio-5.financialcontent.com/investplace/quote?Symbol=V
  5. MA: http://studio-5.financialcontent.com/investplace/quote?Symbol=MA
  6. COF: http://studio-5.financialcontent.com/investplace/quote?Symbol=COF
  7. TD: http://studio-5.financialcontent.com/investplace/quote?Symbol=TD
  8. BMO: http://studio-5.financialcontent.com/investplace/quote?Symbol=BMO
  9. article: http://stocks.investopedia.com/stock-analysis/2010/roll-with-your-spinoff-pepyummcdcmgbmymjn0817.aspx%22%20%5Cl%20%22axzz1WuJ6yCbC

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