Is Discover Financial Services a Buy?

The financial services industry has been hit hard by the COVID-19 pandemic, but like any other industry, the situation may actually present some level of investing opportunity, depending on the companies being considered. Discover Financial Services (DFS 0.33%), best known for its credit cards, is the smallest (by revenue) of the four major credit card networks -- Visa (V -1.70%), MasterCard (MA -1.20%), and American Express (AXP 0.09%) are the others. 

That smaller size didn't keep Discover's share price from plunging along with the others at the start of the pandemic. Like much of the financial industry, shares remain dramatically lower, losing roughly 33% of its value year to date, but are up from their worst lows in late March. Is now the right time to invest in the company, or is that a signal to stay away?

The underdog in the industry

Discover is similar to American Express in that they both issue credit cards to customers as well as provide the networks that facilitate the cards' transactions. This is different from Visa and Mastercard, which both operate transaction networks but work with banks that actually issue the credit cards. You can use a multitude of different types of cards issued by financial entities like Citibank or JPMorgan Chase wherever Visa and Mastercard are accepted. Discover cards, in contrast, are issued through its own bank and can be used only on the Discover network.

Image source: Getty Images.

These days, roughly 99% of U.S. merchants accept Discover cards as a payment option, but they may not be accepted everywhere globally. Discover Financial is still fighting a bit of an underdog battle to prove its worthiness as a favorable credit card alternative.

Even when factoring in all the various services Discovery Financial offers (which include a consumer bank, home and student loans, and payment systems), it's the smallest of the credit card networks in terms of revenue. American Express offers credit cards and loan services and Visa and Mastercard focus just on their credit networks. 

Note: All figures are for the equivalent first quarter of 2020. Data source: Discover, American Express, Visa, and Mastercard quarterly reports.

These days, there isn't anything particularly distinguishing about the company's credit cards. They are reward-focused like most other credit card offers. In the past, Discover set itself off from the pack because it was the first credit card to offer cashback on purchases. Currently, the company differentiates its financial services, in part, by focusing on college students and offering support for managing college finances and things like the FAFSA (Free Application for Federal Student Aid) program, which can be challenging for students. It also operates a payment program to fund tuition in some schools.

Making it through the pandemic

Discover Financial was hit with the same problems as every other banking entity when the coronavirus pandemic hit, including taking a hit on its banking revenue caused falling interest rates and the reduced net income due to making required provisions to account for potential recessionary losses. As we can see in the chart above, these issues meant it was the only credit card network that posted first-quarter losses in net income. That might be because it's a bank in addition to being a network, which American Express, even as a loan issuer, is not.

Perhaps in that sense, it might better be compared to Capital One (COF -0.32%) or Synchrony (SYF 0.15%), which are both banks that have large credit card divisions.

Note: All figures are for the equivalent first quarter of 2020. Data source: Discover, Capital One, and Synchrony quarterly reports.

Discover took the same provisions for losses as Synchrony, which made a billion more dollars in the first quarter, and that sank its net income. However, its charge off rate, which indicates the percentage of loans that are counted as losses, was better than both of those. This suggests that Discover customers pay back their credit card loans, and that's a good sign for the bank. Discover CEO Roger Hochschild pointed out that customers with FICO scores below 660 make up only 19% of the total, whereas during the financial crisis in 2008 that number was 26%, so the company is in better shape to handle a larger-than-normal bump in the road.

The first quarter, which ended March 31, only represents a small amount of the time period affected by COVID-19 and otherwise covers normal operations. The second quarter will encompass the majority of lockdown time, and as of the end of April, Hochschild said: "As long as stay at home orders remain in place and many businesses remain closed we expect the weak sales volume trend to continue and future trends will depend upon the pace of the recovery." While adjusted sales volume in the first quarter increased by 2%, it was already down 29% toward the end of April. And while grocery revenue increased 16% in that time period, it was offset by gas decreasing 60% and other retail decreasing 10%.

How do shares perform?

Like most bank stocks, Discover's share price has decreased and is down nearly 38% year to date. Over the past five years, it's stock has decreased in value while the market has increased.

Discover's shares are trading at only nine times trailing 12-month earnings, while American Express has a P/E ratio nearly double that number. In that sense, one might say it's a good value, but only if you believe that Discover will start catching up with American Express's earnings, and I'm not convinced.

Discover's business has been hit hard by the pandemic, and I think that the decreased stock price is an indication of issues that are not going to go away so fast. There are similar companies that offer greater value, so I would say to look elsewhere if you are considering an investment in the financial sector.