Discover Financial Services: A Cheap Bet on a Recovery

In some respects, Discover Financial Services (NYSE: DFS  ) has been a victim of its own suite of products. Unlike traditional credit card leaders Visa (NYSE: V  ) and MasterCard (NYSE: MA  ) that have company descriptions that appear to be copied and pasted from each others' investor-relations' pages, Discover has its fingers in several financial pies.

Some key differences
Visa and MasterCard partner with financial-services companies to enable the use of their credit, debit, and prepaid banking services for customers, a model that's clearly worked well. But Discover does away with the middleman and goes straight to the consumer, providing direct banking, payment services (credit cards, prepaid debits, and the like), CDs, and other banking products.

Diversification in product lines and sectors can be a good thing -- unless it happens to include banking in today's low interest, investor-beware financial-services environment. In addition to facing less-than-ideal investor sentiment, unfortunately for Discover these key distinctions also place the company directly in the path of $64 billion industry leader American Express (NYSE: AXP  ) .

Make no mistake: There are obstacles to overcome for Discover Financial. Some are external, like a tough lending environment and less-than-ideal loan and credit card portfolios,  but there was also an ill-timed increase in student loans at the end of 2011, and the company carries a whopping $19 billion debt load to boot. Though both external and internal circumstances have kept Discover's valuation depressed compared with the industry, they have also provided value seekers with a nice opportunity going forward.

Mostly positive external factors
The recently announcement of the highest homebuilder confidence level in more than five years substantiated (at least until next month's report) what many have thought for some time now: What had been the laggard in the slow economic recovery is finally coming along. The housing news is certainly good to hear for Discover, particularly as it comes less than a week after the company announced the launch of Discover Home Loans -- the foray into originating home loans direct to consumers.

Add continued strength in consumer spending along with stabilizing -- if not actually improving -- unemployment claims to the recent upbeat economic tidings, and things appear to be falling in line for the lending industry.

June's $6.5 billion jump in the use of consumer credit was disappointing to some, primarily because it looked paltry coming on the heels of March's $12.4 billion rise. Sure, the month wasn't overwhelmingly positive, but it wasn't quite "the sky is falling" material, either. What should cause investors of pure-play credit card companies to take notice was the decline in revolving debt -- in other words, traditional credit cards. Consumers appear willing and able to spend, but on their terms. And that bodes well for lenders and credit card companies -- like Discover and American Express -- with direct-to-consumer alternatives.

Mostly positive internal factors
Along with the improving margins has come stronger cash flow, something that should help mitigate too much angst. But for potential investors, Discover offers plenty of value, too. Currently trading for about half of American Express' 13.6 times earnings, Discover certainly provides the slightly more aggressive long-term value investor some growth opportunity. How does the value compare with credit card behemoths Visa and MasterCard? Discover is trading at about one-fourth the earnings multiples of either one.  Sure, it'd be easier to go with the big boys, but for upside potential you'd be hard-pressed to find a better option than Discover.

If you're not afraid of the banking and financial industries -- you wouldn't be alone if you were -- there are some real values to be had beyond Discover Financial Services. For more options like Discover, take a look at our free special report "The Stocks Only the Smart Investors Are Buying."

Fool contributor Tim Brugger currently holds no securities positions, including any mentioned in this article. The Motley Fool owns shares of MasterCard. Motley Fool newsletter services have recommended buying shares of Visa and creating a write covered strangle position in American Express. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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