Payment companies and major credit card companies endured a difficult 2021, and the struggles have continued through the first two months of 2022. But there were some companies that held their own in this broad space, including Discover Financial Services (DFS 0.20%).
Discover may not be the first credit card company that comes to mind for most investors, but it has been very successful in recent years and is going against the grain this year, trading relatively flat year to date through Feb. 24 while many other stocks have been getting hammered.
Here's why this is an under-the-radar growth stock to hold in your portfolio.
Steady and sustainable growth
Discover Financial is different from the major credit card companies in that it is both a bank and a payment processor. So, through its bank, it loans the money to customers for purchases and then collects on the fees when the purchase is made and generates the interest income when the loan is repaid.
As a bank, it has more credit risk than Visa or Mastercard, which are strictly payment processors. During the pandemic, when default rates rose, Discover's stock lagged the other two because, among other things, it got hit with high provisions for loan losses. However, it still managed to outperform most banks since nearly all had negative returns in 2020 as loan activity slowed and they were hit with even more massive provision for loan losses.
Discover finished the year in positive territory, with its stock price up about 10% in 2020. It finished the year with net income up 13% due to superior expense management and lower provision for credit losses, as the company had strong credit quality with net charge-offs and delinquencies lower than the previous year. Customers weren't charging for things they couldn't afford. Plus, while credit card loans were down about 5% for the year, its noninterest payment services income was up about 6% year over year, buoyed by higher volume and spending on its Pulse network of ATM and debit cards as purchase patterns changed due to the pandemic.
In 2021, Discover had a strong year, with the stock price up 29.8%, outperforming the two major credit card companies. As the economy improved, credit card volume increased, as did loan activity and earnings. Net income was up 34% year over year in 2021, and earnings per share was up 41%. Unlike many payment companies, its growth was steady and sustainable, so it didn't become overvalued, nor did it suffer as bad from the pullback. It gained 2% market share on Visa and Mastercard last year.
Poised for growth in a rising rate environment
The look back at the past two years provides a glimpse into the resilience of this stock and its ability to weather various market conditions. A big reason is its efficiency. Because it is an online bank, it has lower overhead costs with no brick-and-mortar branches. Its operating efficiency ratio was 39.8% at the end of 2021, down from 40.8% at the end of 2020. That represents the expense it takes to generate a dollar of revenue. Its return on equity is 44.9%, which is extremely high, and its operating margin is also high at 49.1%. This efficiency was a major reason it was able to navigate a very difficult year for banks in 2020.
Discover also stands poised to thrive in this current market, which is different from the last two years. The Federal Reserve Board is slated to raise interest rates starting in March, with the expectation that there will be multiple rate hikes. On the fourth-quarter earnings call, CFO John Greene said that Discover expects loan growth in the high single digits in 2022 and higher loan yields from increasing interest rates.
Over the last 10 years, through Feb. 21, Discover has posted an average annual return of 15%. This speaks to its efficient management and robust business model, as it is able to navigate various market cycles. With a price-to-earnings ratio just below 7, Discover has flown under the radar, but that's good news for investors who are looking for a good stock to add to their portfolio.