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The market as a whole, and credit card companies in particular, have been soaring of late. Specifically, over the past year while the SPY (as a proxy for the market) is up just over 23%, American Express (AXP), MasterCard (MA), Discover Financial Services (DFS), and Visa (V) are up 33%, 38%, 42%, and 50%, respectively over the same time frame. See the chart below.


(Click to enlarge)

Given the current market run up, as noted in previous articles of mine I am becoming increasingly wary of an impending pullback. Moreover, given the run-up it is increasingly difficult to find strong value plays at current levels. With these sentiments in mind, after analyzing the credit card marketplace, I believe that despite its recent run-up, Discover remains a strong value play.

As a preliminary remark, it should be noted that not all credit card companies are alike. Specifically, there are two primary types of players involved in the functioning of a credit card: the issuer (aka members) and the payment processors. While American Express , MasterCard , Discover Financial Services , and Visa are all payment processors, only American Express and Discover are in addition issuers of their own cards. Visa and MasterCard on the other hand are strictly payment processors.

Issuers vs. payment processors -- the basics

The issuer is a bank or credit union that makes the credit limit available to cardholders. The issuer is responsible for sending payments to merchants for purchases made with credit cards from that bank. Also called member banks. For example Chase (CCF) and Citi (C) are some of the biggest credit card issuers. Additionally, American Express and Discover are also credit card issuers.

On the other hand, payment processors are responsible for verifying cards used in transactions and transferring money from the card being used in a transaction. The processors subtract a percentage from the amount being paid, and pay a portion of that percentage to the credit issuer as commission. American Express, MasterCard , Discover Financial Services, and Visa are all major payment processors, with Visa and MasterCard being the market leaders in terms of size.

Comparing the two models; and acceptance of Discover Card

To basically we have two models, the Visa, MasterCard model which focuses on payment processing, and the American Express, Discover model that is horizontally integrated (a fancy way for saying they take care of everything in house). The benefits of Visa, MasterCard model is the cards are accepted everywhere because they are issued by banks which are everywhere. Moreover, another benefit of the Visa, MasterCard model is that the financial risk is limited as they are really only a middle man making a small commission. On the other hand, the American Express model has the benefit of the whole operation, and in particular all the profits, in house. On the other hand, as we all know the downside of the American Express, Discover model is that the cards are less widely accepted.

To be sure, with the passing of time, this issue is becoming increasingly mitigated. For example, despite its relatively short history discover card is now accepted at over 90% of stores in the U.S. that accept Visa and MasterCard. Moreover, while discover is notoriously bad for acceptance in Europe, Discover is accepted everywhere in China, because of their alliance with China Union Pay, the most dominant domestic credit card in China. Most importantly however, discover recently struck a partnership with Paypal (last august). As internet transactions continue to grow and perhaps even eventually become the most dominant form of transactions, this partnership will continue to render discover cards issues with wide acceptability irrelevant.

Fundamentals and Valuation

Considering the following table of fundamentals on the four major credit card companies, American Express, MasterCard, Discover, and Visa.

Discover

American Express

MasterCard

Visa

Market Cap

$23.38B

$82.69B

$69.47B

$117.30B

P/E

10.43

18.99

25.06

50.63

Forward P/E

9.87

14.31

19.02

20.84

Price/Sales

3.38

2.75

9.19

10.43

Price/Book

2.41

4.25

10.3

4.31

First, note that on based on P/E ratio and more importantly based on forward P/E ratio, Discover is the best value play among the four by a wide margin. In particular, DFS's forward P/E ratio is under 10! Moreover, on both a price to book and price to sales ratio DFS is a bargain relative to its peers. It should be noted when considering the above fundamentals of the four major credit card companies that only American Express is truly comparable to Discover . For as noted above, MasterCard and Visa are only payment processors whereas Discover and American Express are also issuers.

Dividends

Discover currently pay a 1.7% dividend. This compares very favorably with MasterCard's 0.4%, Visa's 0.7%, and AXP 1.2% dividends. Furthermore, with a payout ratio of 10%, the dividend payment is very secure (for comparison, American Express has a payout ratio of 20%, Visa has a payout ratio of 31,% and MasterCard has a payout ratio of 7%).

Furthermore, Discovers dividend payout has been growing VERY nicely recently. In 2010, 2011, 2012, and 2013 (projected) the annual dividend payouts were $.08, $.28, $.44, and $.80, respectively. This represents an annualized 1,2,3 year increase of 81%, 68%, and 105%! To be sure, a longer term history of the dividend is not as rosy as during the financial crash of 2008 the dividend was lowered from $.24 in 2008 to $.08 in 2009, in other words the dividend was cut by 66%. In other words Discover was hit pretty hard by the financial crisis. In part this is a function of the fact that unlike Visa and MasterCard, Discover is its own issuer so it takes on itself the financial risks of the industry.

Institutional Ownership and Low Volatility

87% of DFS's float is held by 650 Institutional & Mutual Fund Owners. This kind of well balanced and steady ownership is a key reason behind Discovers low beta (.92). Furthermore, insider ownership accounts for roughly 1% (of the remaining 13%) of float. In other words, there is really only 12% of the float out there being traded by everyone else.

Recommendation

The credit card industry as a whole has been flourishing of late. DFS in particular appears to be a strong value play at its current valuations. DFS's horizontally integrated business model as well as their strong recent dividend activity make them particularly attractive relative to their peers. Perhaps averaging purchases of DFS over a 6 month to one year time horizon is recommended to help obtain a balanced entry point.

Source: A Credit Card Value Investment: Should Discover Be In Your Portfolio?