The U.S. economy and job market are slowly recovering from the 2008 financial crisis, which affected credit services companies. With the changing economic conditions, the unemployment rate reduced to 7.30% in August 2013 from 7.40% in July., leading to an increase in consumer spending. To monetize this opportunity, credit services companies are taking several measures to increase their customer base by entering into partnerships and expanding their merchant base. Let's find out what opportunities are present to enhance the card business and earnings of three credit service companies.
Benefit from improving economy
Discover Financial Services (DFS) observed an overall growth of 5% or $390 million in its private student loan division. It offers private student loans to students planning to attend undergraduate and graduate schools at both fixed and variable rates. In the U.S., there are currently around 37 million student loan borrowers under the age of 30. Nearly, 60% of the U.S. residents attending college apply for a student loan. According to the Bureau of Labor Statistics, approximately 66% or nearly 28 million of high school graduates are expected to enroll in college in the next few years. According to the Federal Reserve Bank of New York's quarterly report, student loan outstanding balance was up $8 billion to $994 billion in the U.S. in the second quarter of this year. In the U.S., Discover holds a market share of 3.53% in private student loans, and it will benefit from the increasing demand.
Discover credit card loans increased 5% year over year in the second quarter. The growth correlates with the improving economic conditions in the U.S. As the employment rate continues to improve, consumer spending should also increase. In the first half of this year, employers added around 195,000 jobs, up from 180,000 in the second half of 2012. If employers continue to add more jobs in the coming years, disposable income should rise accordingly. If the U.S. economy continues to recover, the total credit loans outstanding percentage of disposable income reaches 9%, and if Discover maintains its 5.5% market share, its average credit card loan balance can reach $55 billion by 2019.
U.S. and emerging markets to drive growth
MasterCard (MA) observed 12% growth in spending on its credit card and debit cards in U.S. in the second quarter of this year. The recovery in the U.S. economic conditions after the 2008 financial crisis was the main growth driver. Also, the unemployment rate has decreased to 7.30% in August 2013 from 10% in 2009 and is further expected to decrease to 6.8% by 2014. With a declining unemployment rate, personal consumption expenditure, or PCE, is bound to increase. According to the EIA, PCE in the U.S. is expected to increase to $9.785 trillion this year and $10.007 trillion in 2014, up from $9.603 trillion in 2012. MasterCard is likely to benefit since it holds 10% market share in the U.S. PCE. The gross dollar value, or GDV, is expected to reach $4.40 trillion in 2014 up from $3.65 trillion in 2012. MasterCard charges an assessment fee of 0.098% of the GDV processed per client, and 30% of its GDV comes from the U.S.
MasterCard's business in emerging markets is growing at a faster pace. The GDV of transactions made using credit and debit cards bearing its logo increased 21% in Africa, Middle East, and Asian countries in the second quarter of this year. In the coming years, it is expected that emerging markets will observe a higher growth in electronic payment use. To capitalize on this opportunity, MasterCard is planning to enhance its merchant and customer relationships. It already signed an agreement with two major banks of Korea this year. The company is also focusing to establish new partnerships with banks and other partners like retailers and several airlines to enhance its card business and increase its GDV. MasterCard can make profits through currency conversion fees, transaction fees, and royalties.
Third party to drive in revenue
On August 7, 2013, American Express (AXP) entered into partnership with Wells Fargo (WFC). Wells Fargo will now issue new credit cards that will be accepted on Amex's network by 2014. Wells Fargo is the largest bank in terms of market capitalization in the U.S. and serves around 70 million customers who will be able to apply for the new credit card through the internet, phone, and at 6,000 retail branches. It also issues Visa branded credit cards that account for 3% of the total credit card loan portfolio.
(We are also bullish on Wells Fargo. Read: Wells Fargo: Still Cheaper For An Entry?)
This will give Amex ample opportunity to expand its credit card business by acquiring more customers. In the U.S., the average amount spent on an Amex card is around $15,000, significantly higher than Visa's average of $1,000 annually. Currently, it charges an average discount rate of around 2.5%, higher than the less than 2% fee charged by banks issuing Visa and MasterCard. This gives Amex strong potential earnings as higher spending allows it to charge a higher discount rate from its merchants.
Amex adopted a third-party licensing model to expand in emerging markets. Under this model, its global network services, or GNS, division seeks partnership with well-established financial institutions to issue its cards. This helps the company enhance its presence outside the U.S. and increase brand image. Amex charges fees based on transaction volume, earns royalties, and currency conversion fees. Over the past four years, the transaction fees earned through third parties increased at a CAGR of 15%. This has primarily driven its strategy to use GNS partnership. With the help of this model, Amex's revenue can grow in the future. It reported 5% quarter-over-quarter growth in revenue from the GNS segment in the past two quarters. Assuming the same growth continues next quarter, third quarter revenue is expected to reach $1.45 billion.
Discover Financial Services
Source: Yahoo Finance
A company's earnings are expected to grow if the forward PE is less than the trailing twelve month, or ttm, PE. All three companies have an attractive valuation since their forward PE is lower than the trailing PE, which shows an upward trend in each company's earnings.
Assuming a slightly better than expected macro environment in the U.S, MasterCard plans to achieve 11%-14% revenue growth and more than 20% CAGR growth in EPS. Amex's deal with Wells Fargo can help it acquire new customers, banks, and partners to issue cards, which will drive higher returns in the future. Due to the improving economic environment, Discover is likely to benefit from an increase in demand for loans. This will drive higher returns in the future, making the stock relatively attractive.
Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Madhu D., one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.