Discover Financial’s Crazy Climb Can’t Continue … Can It?

by Kyle Woodley | August 17, 2012 9:13 am

ElevenBest Discover Financial's Crazy Climb Can't Continue ... Can It?[1]There’s nothing more cathartic than a little redecorating.

At the butt end of 2011, InvestorPlace Editor Jeff Reeves[2] assembled a team of financial-media superheroes for a stock-picking contest — the Ten Best Stocks for 2012[3] — in which each participant picks one stock that investors should buy and hold for all of 2012.

Being the go-getter that I am, I asked if I could join in on the fun. Alas, I was somewhat new to the company, so I was (fairly, I’ll add) turned down.

Still, I liked the spirit of the contest, and it was the funny memory of a social faux pas[4] that led me toward a stock I learned to believe in: Discover Financial Services (NYSE:DFS[5]).

Eight months later, the contest logo is ripe for a refresh.

That’s because Discover has ridden a wave of beneficial trends, its own business competency and a friendly market to 57% gains in less than two-thirds of a year. That’s …

Not bad for the rook, huh? But all back-patting aside …

The point of the Ten Best Stocks for 2012[7] contest is to pick a stock that should beat the rest for the whole year, which means I have to stick around and cheerlead. But people with real skin in the game have a real decision to make, and it’s not tied to the calendar. Namely, should you take the money and run right now, or keep trying to ride this plastic train?

The Bullish Case

One of the original tenets for buying Discover — namely, the explosive growth opportunities for players in the credit card business, an opinion shared by colleague Charles Sizemore[8] — still stands firm. On a wider level, credit card companies will benefit from continued adoption in the U.S. (I still bemoan a local pho joint’s cash-only policy) and developed international economies, and they’re only just beginning to tap into the potential of emerging markets.

That theme has been playing out for most of the biggest names in credit cards. Visa (NYSE:V[9]) has run up 27%, American Express (NYSE:AXP[10]) has gained 21% and MasterCard (NYSE:MA[11]) has returned 15% year-to-date, with all three riding improving fortunes.

Discover itself saw card sales volume jump 5%[12] in the second quarter (reported back in June), with credit card loans up 4%, helping contribute to a 6% YOY gain in revenues. Earnings actually fell 10% from the year-ago period, breaking a streak of earnings growth — but profits were mostly weighed by lower reserve releases, and the $1 per share figure still topped analyst estimates for 99 cents.

Further greasing the wheels of plastic progress is the march of digital payments[13]. Not that whipping out a card was ever difficult, but technology is enabling people to pay via smartphone or just by flashing a smile, and those transactions are linked to credit cards.

Discover itself just cleared the roads for Google’s (NASDAQ:GOOG[14]) pay-by-phone service, Google Wallet[15]. A simple online button click will allow Discover customers to upload their cards to Google Wallet, which in turn lets people pay by tapping their smartphone to a retailer’s terminal.

UPDATE (8/22): Discover also just announced a partnership with eBay‘s (NASDAQ:EBAY[16]) PayPal service in which DFS will work to have more than 7 million merchants accept PayPal through their existing relationship with Discover.

Internationally, DFS recently joined up with Industrial and Commercial Bank of China, a major commercial financial firm in the world’s largest card market, to establish a Diners Club International franchise in the Asia Pacific region.

Discover also has been hitting the bricks hard to diversify its offerings — it launched a new home-loan business[17] earlier this summer, and it now offers fixed-rate private student loans[18].

DFS 300x173 Discover Financial's Crazy Climb Can't Continue ... Can It?
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DFS’ technicals look strong, too. The 200-day moving average remains headed in the right direction, and relative strength, while creeping up to 70, isn’t quite in the danger zone yet. DFS has broken above its upper Bollinger band several times in the past couple months, and currently is flirting with the top of the range yet again.

The Bearish Case

I’m a Cleveland sports fan, so I naturally think that anything good will be followed by immediate heartbreak and possibly the relocation of my team. In fact, after publicly toasting the Indians’ midseason success this year only to watch them crumble in the second half, I’m convinced God might smite DFS just because I’m bragging about it.

DFSvsSPY 300x173 Discover Financial's Crazy Climb Can't Continue ... Can It?
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Of course, if you’re looking for something a little more tangible, you might want to consider the broader market.

Discover might shine on the market’s good days, but it can get downright pissy when the indices so much as sniffle. And as much as I agree that Adam Parker’s call for S&P 1,167 (a roughly 20% decline) is a load of hooey[19], would you really be surprised at some sort of downturn?

I wouldn’t. The markets have made a bafflingly terrific midsummer run[20] amid a pretty gloomy drumbeat of economic news across the world and a swath of earnings warning flares[21] across Wall Street. Reality has to set in at some point. If it does, DFS will take a tumble, too.

Verdict

Despite its run-up, Discover still is an absolute bargain. Its trailing and forward P/E’s sit at 8.8 and 9.5, respectively — compare that to MasterCard’s 25/16 and Visa’s whopping 63/19, but realize that analysts also expect a lot more growth out of those two. While DFS is expected to eventually churn out modest earnings growth around 9% a couple years down the road, it’s also expected to regress a bit in FY13.

But the company is making a habit out of pleasantly surprising analysts, and the spread of its business tentacles could mean a lot of previously unaccounted-for potential.

Discover is a great stock, and still worth buying. However, if you’re worried about a broader-market pullback, you probably shouldn’t be getting into stocks right now anyway[22]. If you already own DFS, and you’re convinced Wall Street’s about to get shelled, take profits, then wait for your chance to get back in. Those who decide to stick it out could suffer some bumps, but will likely be rewarded in the long run.

Kyle Woodley[23] is the Assistant Editor of InvestorPlace.com[24]. As of this writing, he did not hold a position in any of the aforementioned securities. Follow him on Twitter at @KyleWoodley[25].

Endnotes:
  1. [Image]: http://investorplace.com/best-stocks-for-2012/
  2. Editor Jeff Reeves: http://investorplace.com/author/jeff-reeves/
  3. Ten Best Stocks for 2012: http://investorplace.com/best-stocks-for-2012/
  4. funny memory of a social faux pas: http://investorplace.com/2011/12/time-to-explore-discover-financial-services/
  5. DFS: http://studio-5.financialcontent.com/investplace/quote?Symbol=DFS
  6. COF: http://studio-5.financialcontent.com/investplace/quote?Symbol=COF
  7. Ten Best Stocks for 2012: http://investorplace.com/best-stocks-for-2012/
  8. an opinion shared by colleague Charles Sizemore: http://investorplace.com/2012/07/visa-mastercard-v-ma-credit-cards-emerging-markets/
  9. V: http://studio-5.financialcontent.com/investplace/quote?Symbol=V
  10. AXP: http://studio-5.financialcontent.com/investplace/quote?Symbol=AXP
  11. MA: http://studio-5.financialcontent.com/investplace/quote?Symbol=MA
  12. card sales volume jump 5%: http://investorplace.com/2012/06/discover-q2-earnings-fall-but-beat-estimates/
  13. digital payments: http://investorplace.com/2012/08/digital-payments-pluses-and-minuses/
  14. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG
  15. Google Wallet: http://online.wsj.com/article/BT-CO-20120816-710510.html
  16. EBAY: http://studio-5.financialcontent.com/investplace/quote?Symbol=EBAY
  17. launched a new home-loan business: http://www.marketwatch.com/story/discover-financial-launches-mortgage-business-2012-06-12
  18. offers fixed-rate private student loans: http://investorplace.com/2012/06/discover-q2-earnings-fall-but-beat-estimates/
  19. is a load of hooey: http://investorplace.com/2012/08/could-the-sp-really-dive-20-in-4-months/
  20. bafflingly terrific midsummer run: http://investorplace.com/2012/08/5-traders-sort-out-this-weird-crazy-market/
  21. swath of earnings warning flares: http://investorplace.com/2012/08/get-ready-the-earnings-floor-is-set-to-fall/
  22. shouldn’t be getting into stocks right now anyway: http://investorplace.com/2012/07/7-reasons-to-stop-trading-until-thanksgiving/
  23. Kyle Woodley: http://investorplace.com/author/kyle-woodley/
  24. InvestorPlace.com: http://investorplace.com/
  25. @KyleWoodley: https://twitter.com/#%21/kylewoodley

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