Does It Pay to Discover?

I'm intrigued by the recent spinoff of Discover Financial Services (NYSE: DFS  ) . Maybe it's because I missed out on the MasterCard (NYSE: MA  ) party, which incidentally, the Inside Value team nailed. Regardless, after reading Discover's prospectus, I'd rate the current shares as a solid buy.

Discover is a credit card issuer with more than 50 million cardholders and $51.4 billion in managed credit card receivables. It's also unusual in being one of only two issuers -- the other being American Express (NYSE: AXP  ) -- that own their own payment network. Other issuers, such as Capital One (NYSE: COF  ) , issue cards on the Visa or MasterCard networks. Discover is also the only issuer with both credit and debit functionality.

The terrible three or the final four?
The key question facing Discover is whether the now-independent player can hang with the big dogs. According to The Nilson Report, an industry publication, Visa, MasterCard, and American Express dominate the U.S. credit card industry with respective 44%, 31%, and 20% market shares. Discover? A measly 5%.

That's a troublesome figure, because the value of a network is directly proportional to its size -- in other words, bigger is better. For that reason, Discover is rarely a customer's primary card because it isn't as widely accepted among smaller merchants.

Strategy
Discover's key mandate, then, is to increase penetration among mid-size and small merchants. Management recently decided to outsource some of this task to merchant acquirers. Merchant acquirers are banks or other financial institutions -- the intermediaries that handle and process the credit or debit card transaction.

I really like the common-sense rationale behind this decision. Although it means that Discover will have to pay a mark-up fee to the acquirer and won't have a closed loop where the merchant acquirer is involved, the most important thing is that Discover grows its network. And doing so will be a big help in going toe-to-toe with MasterCard and Visa.

What's more, my intuition tells me that the prospect of increased revenues at merchant acquirers such as First Data (NYSE: FDC  ) , Fifth Third (NYSE: FITB  ) , and Heartland will lead them to welcome Discover with arms wide open. I don't think persuading merchants to accept Discover would be too difficult of a sell for merchant acquirers. It's not as if the merchant has to displace Coca-Cola to clear up shelf space for No-Name Genericola.

Tailwinds
Discover has a lot of things going for it, including a loyal customer base. Its cardmembers hold their accounts for an average of 8.6 years, versus 6.2 for the industry. Further, according to a recent study from Cardweb, Discover's attrition rate of 4.5% was half the industry average (the study excluded American Express).

Discover also benefits from the rising tide of favorable industry conditions. Customers clearly prefer the convenience of paying with credit cards as opposed to cash or checks. According to The Nilson Report, U.S. spending volumes on credit cards are forecasted to grow at a 12% pace through 2010.

Valuation
Discover's shares have dropped about 12% from when they were spun off. Their current level gives the company about a $12 billion market cap. But as for earnings, the company pulled in $1 billion in 2006 and $570 million in 2005. The reason for the huge jump is the new bankruptcy legislation that cracked down on debtors and caused a lot of bankruptcy filers to scramble to file before the new rules kicked in.

This action brought a lot of bankruptcy filings into 2005, thus making 2005's credit losses unnaturally high. And that, in turn, makes the year-over-year numbers look unnaturally strong. In 2007, credit losses have normalized, and we can now see that the company's true earnings power is probably somewhere between 2005 and 2006's results.

Year to date, the company has earned about $443 million. There are a couple of adjustments to make post-spinoff, but it gets us in the ballpark. And it allows me to calculate a quick and dirty price-to-earnings ratio of 13 to 14 based on run-rate earnings.

Optionality
Rick Biggs wrote in an article at bankstocks.com that he views Discover as overcapitalized. If so, that opens the door for a substantial buyback. He also noted that Discover's payment-processing network might make it a juicy target for a big card issuer such as Bank of America (NYSE: BAC  ) , which might want to establish its own closed loop to give it leverage against dominant network providers Visa and MasterCard.

The bottom line
Given the stock's drop since the spinoff, a buyback at current prices could be quite the deal for shareholders. For Fools, Discover could prove to be an interesting Joel Greenblatt-esque play. In all, I think there's a lot to like at Discover, and if the shares keep sliding, I might be forced to pull out my wallet.

Related Foolishness:

MasterCard shares have returned more than 250% since being recommended in the Motley Fool Inside Value newsletter service. Check out an all-access 30-day free trial to see what other values Philip Durell and his team of analysts are recommending to subscribers right now.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. Bank of America is an Income Investor recommendation. The Motley Fool has a disclosure policy.


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