Why Discover Financial Services Could Head Even Higher

Shares of Discover Financial Services (NYSE: DFS  ) hit a 52-week high on Monday. Let's take a look at how it got there and see whether clear skies are still in the forecast.

How it got here
As my Foolish colleague Amanda Alix put it on Sunday, it's a great time to be a credit card issuer. There are countless opportunities open to credit service companies, both issuers and processors, since the majority of the world's transactions are still processed in cash.

That's been the drive behind credit card processors Visa (NYSE: V  ) and MasterCard (NYSE: MA  ) , which are focusing on emerging markets to drive growth in areas with unmet credit processing needs. In addition to processing transactions and focusing on emerging-market growth, Discover and rival American Express (NYSE: AXP  ) are also directly lending to customers, with Discover also sporting its own home mortgage operations business.

These many avenues of growth led Discover's transaction volume up by 5% in the second quarter while credit card delinquencies dipped to historically low levels. Even with credit card yields down by 22 basis points to 12.35%, net interest margin managed to increase by 16 basis points to 9.31% as funding costs decreased.

That doesn't mean that there aren't risks involved with Discover's business. Since Visa and MasterCard are just processors, their obligation to the consumer essentially ends there. Discover has to deal with bad debt charge-offs for those who don't pay (but as we just witnessed, those numbers are near record lows). Also, Visa reported in April that transaction volume was down 3%. This decrease was the first in some time and could signal that discretionary spending has waned in recent weeks. Discover has many means of turning a profit, but it clearly relies on its credit division for a significant portion of its revenue.

How it stacks up
Let's see how Discover Financial stacks up next to its peers.

DFS Chart

DFS data by YCharts

Discover has actually been the best performer over the past five years, with American Express lagging the pack.

Company

Price/Book

Forward P/E

Dividend Yield

Discover Financial 2 8.3 1.2%
American Express 3.5 12.8 1.4%
Visa 3.7 18.3 0.7%
MasterCard 8.9 16.3 0.3%

Source: Morningstar. Yields are projected.

As you can tell, there's a significant premium placed on Visa and MasterCard since neither have to worry about consumers defaulting on their loans. AMEX and Discover do, however, contend with the repercussions of bad debt daily and thus trade at a lower multiple. What AMEX and Discover do have is higher projected dividend yields relative to Visa and MasterCard.

If there is one gripe I have with this sector, it's that these companies spend far too much of their free cash on share buybacks when they should be divvying those profits out to shareholders as a dividend. Don't get me wrong, I rate the entire sector investment-worthy and expect it to be the dividend juggernaut of the future, but it's doing a poor job of rewarding shareholders with dividends as of right now.

What's next
Now for the $64,000 question: What's next for Discover Financial Services? That depends on whether or not consumers keep spending, whether Discover can continue to maximize its net interest margin, and whether credit card delinquency rates remain near historic lows.

Our very own CAPS community gives the company a three-star rating (out of five), with 84.6% of members expecting it to outperform. As you can tell from my excitement about the sector, you can count me among those who've made a CAPScall of outperform on Discover and currently find myself up 36 points on the selection.

The best part about Discover -- and the rest of the credit card processing and lending sector, for that matter – is that its growth is still very much in its infancy. The emerging markets offer huge growth opportunities and as we've seen from prepaid debit-card providers like Netspend Holdings (Nasdaq: NTSP  ) , which recently reported a 23% increase in the number of active prepaid cards with direct deposit, and other avenues of domestic growth are still emerging. I see no reason to believe Discover's move higher is anywhere near finished.

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Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool owns shares of American Express and MasterCard. Motley Fool newsletter services have recommended buying shares of Visa, as well as creating a covered strangle position on American Express. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On July 10, 2012, at 3:22 PM, CarenK wrote:

    I have been following Discover Financial for a few months now. Even though it has reached it's 52 week high, I think it is a very good stock to buy and hold long term. Discover Card is planning to enter the private label market. This is a real growth opportunity to expand their brand in the credit card market.

    http://creditfast.com/discover-card-may-enter-the-private-la...

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