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Better Stock: Visa (V) vs. Discover (DFS)

By Eric Volkman – Updated Jan 25, 2018 at 5:38PM

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Does bearishness mean opportunity for Discover, or should investors opt for current market favorite Visa?

Visa (V 0.35%) and Discover Financial Services (DFS 1.71%) are two companies that are either fully or heavily involved in the payment cards industry. However, their fortunes have diverged sharply of late, with Visa enjoying a banner year in 2017 and Discover experiencing what could be characterized as growing pains.

These days, Visa is by far the more popular of the two stocks. But does that make it the superior investment?

One person handing a card to another at a register

Image source: Getty Images.

Open and shut

There's a key difference in the two companies' business models.

Visa is an open-loop operator, meaning that it functions entirely as a processor of the payments made with its card brand. It is not the entity actually lending the money, which is why we get Visa cards from the likes of Bank of America, Citigroup, or one of many other willing creditors. Those creditors are the issuers, i.e., they're the ones lending the money (in the case of credit cards) or drawing from a user's bank account (in the case of debit cards). Visa collects a small fee on each credit or debit card transaction.

Discover is a closed-loop company. Like Visa, it processes the payments made with its card brand, but it's also an issuer. When you buy something with a Discover credit card, Discover is your lender.

There are pros and cons to each approach; suffice it to say that open-loop operators tend to go for volume, while closed-loopers are after credit quality. This explains the wide disparity in the numbers of cards in circulation in the U.S.: Visa's tally at the end of 2016 was 335 million, dwarfing not only Discover's 51.4 million, but also the 47.5 million of the most famous closed-loop operator, American Express (AXP 1.42%).

It also helps explain why Visa tends to be much more profitable: Because it's not a lender, it takes on none of the associated risk. That, along with good macro- and micro-economic factors throughout the world (plus the recent consolidation of a huge acquisition, Visa Europe), has really juiced results.

The company's fourth quarter is a good example: Revenue rose by 14% on a year-over-year basis to almost $4.9 billion, and net income advanced by 11% to $2.1 billion. As has been the case in most of Visa's recent quarters, both figures comfortably beat analyst estimates.

Although Discover is growing well in certain areas -- both overall loans and credit card loans grew by 9% in its latest-reported quarter -- there are concerns about quality. The company sharply increased both its net charge-offs (i.e., loans unlikely to be repaid) and its provisioning for loan losses. These moves dinged profitability, which slipped by 6% to $602 million (on net revenue that rose nearly 10% to $2.5 billion).

For a closed-looper like Discover, growth in loans is encouraging at first glance. But those substantial hikes in charge-offs and provisioning are worrying, and I'm not sure I totally buy management's explanation that these are due to routine factors, such as the "seasoning" of certain loans in the case of the charge-offs. I think the market's trepidation is warranted here.

Follow the leader

That being said, Discover remains well in the black on the bottom line: Its most recent quarterly net profit margin was 24%. Discover's margin has even topped American Express's for several years running. And there's certainly potential for renewed bottom-line growth, given those rising loan tallies.

But we can't ignore the significantly higher spend on charge-offs and provisioning -- or the possibility that this trend will persist or deepen. Meanwhile, if we compare analyst estimates for profitability growth to the current stock prices, we see that Visa trades at only a modest premium: Its five-year PEG ratio is 1.74, while Discover's is 1.25.

In sum, Visa is a company very much on the rise, whereas Discover's growth comes with nagging concerns and thus more than a little uncertainty. That's why my pick in this face-off is Visa.

Eric Volkman has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Visa. The Motley Fool recommends American Express. The Motley Fool has a disclosure policy.

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