The first time my girlfriend flashed her Discover card in front of me, I laughed and blurted out, “Who uses Discover?” The waitress didn’t do me any favors when she said my significant other’s plastic wasn’t any good there.
Little did I know, I’d eventually eat my words. Discover Financial Services (NYSE:DFS) is managing to get its namesake card accepted at more merchants — and investors should give this stock some attention.
Discover Financial Services long has been burdened with a plebian reputation compared to its industry rivals. Visa (NYSE:V) and MasterCard (NYSE:MA) are the sturdy standards of the average consumer. American Express (NYSE:AXP), though not as widely accepted, makes up for that with its “elite” standing and preference among the business crowd.
Discover? It was introduced by Sears (NASDAQ:SHLD) in 1985 and has been struggling to earn respect ever since.
In December 2008, Discover was solely a credit card network, but it joined AXP in seeking approval to become a bank holding company, thus allowing it to tap $1.2 billion in Troubled Asset Relief Program funds. A couple months later, DFS shares bottomed out just below the $5 mark.
My, how things have changed.
While just about every industry has improved since the depths of the financial crisis, credit card companies have come roaring back, and Discover is no exception. DFS stock has more than tripled since its days in the cellar. And while MasterCard and Visa have thumped out roughly 65% and 45% returns year-to-date, respectively, DFS stock hasn’t been a slouch, roping 30% gains in 2011.
But if you’re thinking “buy low and sell high,” Discover is practically begging you to ride a little farther.
The company this month continued its string of earnings beats, though the fourth-quarter difference wasn’t as dramatic as in previous quarters. While EPS of 95 cents came in about 4% above analyst expectations, Discover had beaten estimates by about 30%, 50% and 60% in the previous three quarters.
This growth has come in part because Discover has addressed some of its shortcomings. Since 2010 alone, the number of merchants that accept Discover has increased by 7%. The company banked on this in a big way during the fourth quarter, where DFS saw an 8% bump in sales volume on its cards. Discover’s cash-back rewards also have proven an attractive lure to consumers looking for ways to squeeze out an extra buck.
In a conference call, Discover executives pointed out that these trends have helped their cause: More DFS customers are using Discover as their “primary card” over the rest of the plastic in their wallet.
The growth potential is attractive. But equally compelling is Discover’s bargain-basement valuation. DFS sits at a forward price-earnings ratio less than half its bigger counterparts. Even if we meet somewhere in the middle — a P/E of 10, between Discover’s 7.2 and Visa’s 14 — on DFS’s expected earnings per share of $3.34, you’re looking at a nearly 50% return next year.
And if that P/E gets to 14 based on earnings projections? You’ve got a doubler on your hands.
Maybe one of the best reasons to get confident about Discover is its dividend growth of late. While DFS scaled back its payout to 2 cents per share during the financial crisis and let it languish there through 2010, it hiked the dividend back up to the pre-crisis level of 6 cents this April, and in 2012, shareholders will enjoy a full 10 cents per share. That’s a five-fold increase in five quarters!
Other positive points? Consider the recent trend reversal that saw credit card use overtake debit card use. Or more important, the still-increasing adoption of credit cards in the U.S. and booming expansion abroad. Discover already operates in 50 countries, including the swelling emerging economies of China and Brazil, and the company is gearing up to branch out in European strongholds Germany and the U.K.
Discover and other cards magicked up fantastic growth this year despite an unimpressive financial environment, and the prospects ahead are positive without even considering the possibility of a robust economic jolt in 2012. While Visa and MasterCard look like no-brainer picks going forward, Discover looks like a no-brainer value pick — which is better in my book.
And honey: I’m sorry.
As of this writing, Kyle Woodley did not hold a position in any of the aforementioned securities.
