Which is a better buy for investors at current values between the two credit card-issuing financial companies American Express Company (AXP 6.22%) and Discover Financial Services (DFS 0.87%)?
Both companies have near-identical business models. That means the answer to "Which is a better buy?" has to be answered by focusing on valuation and thinking about each company's story.
But first, some background
Both AmEx and Discover issue their own credit cards and loan out money to consumers. This stands in stark contrast to two other credit companies, Mastercard and Visa, neither of which actually loan money to consumers.
There are pros and cons to this model. The obvious upside for American Express and Discover investors is that consumers pay a lot of credit card interest each year and both these companies stand to profit from that interest. The negative is that the companies face the default risk that comes from lending money.
The two companies' stock prices share similarities as well. Both have struggled to bring even mediocre returns to its investors over the past couple of years, though both are well off their lows.
American Express is still reeling from the loss of its co-brand card relationship with Costco, while Discover is most recently struggling from a perception of increased loan default risks. But the news isn't all bad. Surprisingly, both share the distinction of having the most loyal customers among their credit card peers. So which company makes for a better investment right now? Let's take a closer look and see what we learn.
Image source: Pixabay.
Is there value to Discover?
Since reporting its 2017 first quarter results late last month, Discover's stock price has dropped about 10%. Investors were spooked by Discover's sharp increase in its net principal charge-offs and loan loss provisions. Charge-offs is debt Discover has issued that it deems unlikely to be collected. Charge-offs rose to $489 million, a 31% increase year over year and loan loss provisions increased even more, showing a 38% increase year over year.
Image source: Discover Financial Services 2017 Q1 Earnings Presentation.
With our focus on consumer lending, asset quality has a large and direct impact on our bottom line. That's one reason why prudent risk management underlies all we do.
Nelms stressed the company was only looking for additional opportunities in the prime market, not with sub-prime borrowers. If they can overlook Discover's credit risk, there are plenty of reasons for investors to be optimistic. Revenue net of interest expense increased 5% year over year to $2.34 billion. Earnings per share increased 6% year over year to $1.43. Its total loan growth was 8% and was driven by growth across all its different loan portfolios including credit card loans (7% growth), personal loans (20% growth), and private student loans (3% growth).
While the credit risks are growing and growth is only modest, what makes Discover compelling is its current valuation. With a trailing twelve-month EPS of $5.84 and a current stock price of just over $60, Discover's price-to-earnings ratio stands at a paltry 10.3. While this is a steep discount to the overall market, it should be noted it is fairly in line with card-issuing peers like Capital One and Synchrony Financial.
Can this Express turnaround?
American Express remains a tale of two companies. On one hand, its first quarter total net revenues decreased by 2% year over year to $7.9 billion. Its net income was down even more to $1.24 billion, a 13% year over year decrease. On the other hand, however, once its revenue was adjusted for foreign exchange rates and the loss of the Costco business, it showed an increase of 7%. Its total loans grew 12% to $65.3 billion, a faster growth rate than the industry-a trend the company has continued for several years.
Image source: American Express Company 2017 Q1 Earnings Presentation.
In the conference call, CFO Jeffrey Campbell stated "more than 50% of the growth in U.S. consumer loans" came from existing loans. For American Express investors, this is good news. Convincing existing customers to take out more loans or opening new cards comes at a much lower cost than acquiring new customers. American Express will also have a much better understanding of the credit risk for existing account holders than it would have for new account holders.
With a trailing twelve-month earnings per share of $5.52 and a current stock price of about $77.50, American Express sports a price-to-earnings ratio of just a shade over 14.
Which credit card company is a better buy?
I believe Discover remains an undervalued financial company. In a market where stodgy companies with nominal growth regularly sport P/E ratios of over 20, Discover's valuation is about half that. Yet investors remain skittish when it comes to credit risk; after all, it is still less than a decade since the financial crisis. And, if Discover's loan loss provisions and charge-offs continue to rise, it might take the patience of Job for an investor to see through an investment in Discover until it is fairly valued.
American Express, though more richly valued than Discover, is probably the better investment today. Its credit risk is less than Discover's. Yes, it is still feeling the loss of Costco's business, but the year over year comparables will eventually lap the loss of the wholesale supermarket chain and the company will show top and bottom line growth once more.
