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Discover Financial Services (DFS) is a direct banking and payment company known for its Diners Club benefits. The company's main services include credit cards, personal banking and student loans. Discover Financial Services was previously a part of Morgan Stanley (MS) and was spun off just before the 2008 financial crisis.

Discover acquired Diners Club from Citigroup (C) in 2008, and since then, the program has expanded rapidly, creating an international network for Discover Cards, offering processing services through its pulse network and offering personal loans.

Financial And Peer Review

Discover Financial Services reported a net income of $551 million or $1.07 per diluted share for the fourth quarter of 2012, as compared to $513 million or $0.95 per share for the fourth quarter of 2011. For the latest quarter, total loans, credit card loans and Discover card sales volume rose by 6% from last year. Pretax income from direct banking was up 7% from last year. Net interest income for the company grew by 11%, backed by loan growth and lower interest expenses.

The company's board declared a cash dividend of $0.14 per share for the common stock, an increase of about 40%, payable on January 17, 2013. During the quarter, the company also repurchased about 10 million shares of common stock for $401 million, resulting in a 2% decline in the total shares outstanding. Discover also announced a new share repurchase program of $2.4 billion, replacing the previous prior $2 billion share repurchase program.

Despite such strong financials, it is surprising that the company is trading at such a deep discount compared to its peers. One analyst even claims an upside of between 35% and 40% is expected for the stock, based on strong earnings performance and remarkably low valuations.

When compared to competitors like MasterCard (MA) and Visa (V), Discover looks a bit undervalued with a P/E of only 9.26x against 24.05x for MasterCard and 44.8x for Visa. The PEG ratio for Discover is also low at 0.87 compared to the industry average of 1.14. Discover's price to sales ratio is at 3.02, which is also less than its peers, with MasterCard at 8.76 and Visa at 9.94. In last year's fourth quarter, Discover missed the EPS by 6 cents, while Visa beat in both 4Q 2012 and 1Q 2013. MasterCard also beat estimates several times in 2012.

Push Into Direct Banking

A few weeks ago, Discover Financial Services announced that it plans to offer home equity loans by the second half of the year. Best known for its namesake credit card, the company now intends to move further into direct banking. Discover expects to give fixed-rate home equity loans between $25,000 and $100,000 to homeowners looking to consolidate debt. The company now also offers auto, personal and student loans. In June last year, DFS acquired Tree.com's mortgage business and has since funded more than $2 billion in residential mortgages.

Agreement

Discover and Interswitch Limited, the largest integrated payment processing service provider in Nigeria and promoter of the leading card network have entered into an agreement that will allow the acceptance of Discover and Diners Club International (DCI) cards at Interswitch-enabled ATM and point-of-sale (POS) terminals for purchases in Nigeria. The deal will also allow Verve cardholders to access Discover, Diners Club International and PULSE networks for international purchases and cash access outside of Nigeria.

The agreement will help Discover to boost transaction volume on the Discover, Diners Club International and PULSE networks.

What Experts Expect

Discover Financial Services has been awarded a number of updates in ratings from brokerages and research firms, inluding:

  • Credit Suisse has reaffirmed its DFS "outperform" rating with a price target of $47.
  • Barclays Capital has raised its price target for DFS from $45.00 to $48.00 with an "overweight" rating on the stock.
  • An analyst at TheStreet has reaffirmed the "buy" rating for DFS. As per the analyst, growth can be noticed in multiple areas, like solid stock price performance, increase in net income, revenue growth, good cash flow from operations and expanding profit margins.
  • JPMorgan Chase reaffirmed its "overweight" rating with a price target of $45.
  • Analysts from Bank of America reaffirmed their "buy" rating with a price target of $47. Analysts are bullish on its earnings power and potential to distribute capital to shareholders.
  • RBC Capital reaffirmed its "top pick" rating for Discover with a price target of $50.

Conclusion

Discover is truly a global company with 20.8 million total merchant locations, 12 million of which are 8% outside of North America. There is no doubt that cashless transactions are the future and are still nascent in emerging markets. This infrastructure will surely help the company to enhance profitability over the longer term.

Even the insiders are pretty confident about the prospects of the company, with CEO David Nelms holding 1.97 million shares, at a market value of $78 million. Discover has strong growth prospects backed by limited institutional ownership, strong insider holdings and a shareholder-friendly repurchase program. With such prospects, Discover will be a good addition to one's portfolio.

Source: Discover: The Secret Weapon In The Credit Vs. Cash War

Additional disclosure: Black Coral Research is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.