Dividend stocks are everywhere, but many just downright stink. In some cases, the business model is in serious jeopardy, or the dividend itself isn't sustainable. In others, the dividend is so low, it's not even worth the paper your dividend check is printed on. A solid dividend strikes the right balance of growth, value, and sustainability.
Today, and one day each week for the rest of the year, we're going to look at one dividend-paying company that you can put in your portfolio for the long term without too much concern. This isn't to say that these stocks don't share the same macro risks that other companies have, but they are a step above your common grade of dividend stock. Check out last week's selection.
This week, we're going to look at a dividend juggernaut of the future, Discover Financial Services (NYSE:DFS).
It's all in the numbers
I know what you must be thinking, "But, the yield is only 1.4%! Why don't I just go find a nice yielding CD instead?" The answer as to why you're not going to do that is because Discover offers investors a chance to profit from significant price appreciation as well as dividend growth over the long term.
Discover's fourth-quarter report tells you everything you need to know about where its business is headed. For the quarter, Discover's total loans, credit card loans, and Discover card sales all grew by 6% as adjusted income rose to $1.07, return on equity hit a robust 23%, and credit card charge-offs hit a record low of 2.29%. Of course, things aren't picture-perfect as credit card yields actually fell by 20 basis points to 12.16% from the year-ago period, but its overall net interest margin rose 34 basis points to 9.44%.
Record-low interest rates have spurred spending on multiple fronts and are serving to expand the credit services pie rather than pit expanding companies against each other. With multiple international markets largely untapped, and even numerous domestic channels still in their infancy, like mobile payments, processor/lenders like American Express (NYSE:AXP), and pure-play processors Visa (NYSE:V) and MasterCard (NYSE:MA) are no longer stepping on each other's' toes in order to grow their bottom line.
Credit, and debit, and partnerships, oh my!
One case in point that I've noted previously where Discover and American Express are at a distinct disadvantage relates to Visa and MasterCard acting strictly as payment facilitators and not lenders. This absolves Visa and MasterCard from any chance of payment default if the economy turns south. While that point does indeed have me favoring Visa and MasterCard, there's a major counterpoint that demonstrates Discover can grow just as quickly. Because of its lending ability at an average rate of 12.16% in the most recent quarter and it's considerably tougher lending practices since the downturn, even with the acceptance of what's been a record low in net charge-offs, Discover's return on equity can sometimes trounce that of Visa and MasterCard -- or, at worst, run a very close second.
Domestically, processor/lenders like American Express and Discover are making waves by entering a market previously occupied by smaller credit service companies: prepaid debit cards. With the financial crisis a few years ago ruining many people's credit, prepaid debit cards have become an instant hit and big moneymaker for credit service companies. American Express announced its intent to enter the prepaid debit card market in 2011 and announced a partnership with Wal-Mart last year. Discover, like AMEX, offers multiple prepaid debit card and gift cards, and with $37 billion being loaded on prepaid debit cards annually according to Bankrate, there's a wide moat for everyone to take advantage.
Partnerships are another key factor that propel financial service companies like Discover to success. If American Express' deal with Wal-Mart sent shivers down Green Dot and NetSpend Holdings' shareholders' spines, then Discover's partnership with eBay's (NASDAQ:EBAY) PayPal should have put the entire sector on notice. In an escalating mobile payment battle with privately held Square, eBay landed Discover as a partner just two weeks after Square landed Starbucks. The move, as TechCrunch notes, allows Discover's network of more than 7 million domestic merchants to accept PayPal as a form of payment. This doesn't even count the number of merchants that could eventually accept PayPal internationally.
A dividend juggernaut in the making
Perhaps the most exciting factor about Discover is its potential for future dividend growth. I admit, a 1.4% yield doesn't exactly turn heads now, but Discover's payout has been growing rapidly and is just a fraction of its annual profit meaning it is likely to head higher as the company turns its attention to paying out its excess capital to shareholders:
As you can see above, Discover's quarterly payout has jumped sixfold, from $0.02 to $0.14, in just the past two years. Based on Discover's new payout of $0.14, it's on pace to pay out just 12.8% of projected 2013 earnings, leaving plenty of room for a sustained payout and lots of future growth.
Credit service processors and lenders are in the midst of a huge growth opportunity with record-low domestic interest rates spurring spending and prepaid debit card growth surging. Internationally, untapped emerging markets offer a seemingly limitless opportunity for processors like Discover. Because the size of the global credit market is expanding so rapidly, all processors and lenders can grow without fear of losing significant (if any) market share to their rivals. As one of the premier credit processors and with charge-offs at historic lows, it seems only natural to expect further dividend hikes and continued outperformance from Discover moving forward.