Don’t Turn Your Nose Up at Discover Financial Services (DFS)

Forget Discover's old rep - the company's cards have gained mass acceptance, and DFS stock is priced just right


Apple (AAPL) made news this week with a leaked rumor of a deal with credit card giants Visa (V), MasterCard (MA) and American Express (AXP) that would transform the new iPhone 6 into a viable mobile wallet.

Discover Financial Services DFS stockConspicuously absent was any mention of the third-largest American credit card brand by cards in circulation, Discover Financial Services (DFS), operator of the Discover and Pulse networks.

And yes, I said “third.” Despite its lower profile, Discover has more cards in force than the much older and more prestigious American Express: 61 million vs. 52 million, respectively, based on latest head-to-head comparisons. (However, based on purchase volume, Discover remains a distant fourth.)

Why You Should Side With DFS

Investors in DFS stock shouldn’t fret about the Apple snub; as I explained in my last article, I expect the iPhone mobile wallet to have a negligible effect on credit card transactions volumes.

Far more significant is the fact that Discover has almost entirely closed the acceptance gap between itself and Visa and MasterCard, at least in the U.S. The number of merchants accepting Discover had grown by 24% since 2009 to 9.2 million at the end of last year. Visa and MasterCard are accepted by about 9.4 million merchants.

At least within the U.S., it is now rare to find a card-swiping merchant that does not accept Discover.

Furthermore, Discover recently tied with American Express as the card with the highest customer satisfaction, according to J.D. Power’s rankings. The survey measured factors such as card terms, rewards programs and customer service. Discover’s leap to the top is significant when you consider that American Express sells itself as a prestige card for business and high-net-worth consumers.

So, who are all of these Discover cardholders?

Using data from ESRI, Pam Allison did an interesting study of the demographics of Discover cardholders. True to its origins as a Sears (SHLD) product, Discover tends to be most popular in the prairie and Rust Belt states of the Midwest and tends to be popular with an older, more conservative segment of the population — the segment of the population you would most expect to see shopping at a local Sears store. From a risk management perspective, that’s not a bad thing; consumers in this profile are less likely to get overextended and become delinquent in their payments.

Of course, this conservatism also makes them less likely to do a lot of transaction volume.

Writing for MarketWatch, editor Jeff Reeves recently called Discover stock “the best financial stock to buy today” based on its strong earnings growth, loyal customer base, shareholder-friendly dividend boosts and share buybacks, and its recent diversification into non-credit-card businesses such as student loans and mortgages.

I would add that Discover is also quite cheap, trading for 13 times trailing earnings and 11 times forward earnings — or about half the valuation of rivals Visa and MasterCard.

Granted, Discover — like American Express — is an actual bank with all of the risks associated with it. Visa and MasterCard are essentially tollbooth operators; they are payment systems rather than lenders, and as such have higher margins and no credit risk.

So, all else equal, Visa and MasterCard should trade at a premium to Discover and American Express … though a gap as large as today’s would seem a little extreme. Furthermore, Discover is significantly cheaper than American Express, which trades for 18 times trailing earnings and 15 times forward, and this despite American Express having significantly lower margins.

Bottom Line

Discover Financial Services cannot match MasterCard or Visa internationally, and both have made expansion in emerging markets a major strategic focus. But of the four major credit card stocks, DFS would seem to be the best overall bargain by a wide margin.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.

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