These 4 Stocks May Be Inoculated From Credit Card Hacker Flu

Includes: AXP, BFOR, DFS, FAS, FAZ, MA, V, XLF
by: John Morgan

The Target (NYSE:TGT) data theft affecting about 100 million Americans, while dramatic in itself, reveals a simmering volcano beneath the broad U.S. credit-based payments and transactions system.

The coming eruption will produce significant winners and losers in coming years.

The result could be a profit bonanza for well-positioned stock investors.

The potpourri of constituents involved includes retailers of all sizes; big bank card issuers like Citi (NYSE:C) and Chase (NYSE:JPM); payment network players who should figure very prominently in the industry's future; and hopeful intruders like the wireless carriers and Internet giants such as Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG).

In the evolving ecosystem, the retailers clearly will survive but their near-term transaction costs are bound to go higher.

Meanwhile, the big banks may collide eventually against wireless carriers, Internet giants, and other digital gate-crashers who have yet to emerge. It is currently impossible to divine who among these parties will endure and thrive in the transaction space in the longer term.

In fact, the standout winners in the industry are likely to be the dominant payment networks - Visa (NYSE:V), MasterCard (NYSE:MA), Discover (NYSE:DFS), American Express (NYSE:AXP) - for good reasons: (1) they have managed to be neutral Switzerland for the other parties, (2) they are integral to the outcome; and (3) they have managed to lay off significant expense risk on others; (4) they are undervalued relative to their clear growth prospects.

The Target experience is illustrative. With the compromise of card data of millions of Target customers by hackers, the consumer payments industry is faced with the necessity to abandon the vulnerable, outmoded magnetic card-swipe system currently in place at retail.

By most accounts, the industry will replace magnetic-swipe cards with embedded chip cards. But who will pay for that migration?

By most accounts, the card issuing banks (Chase, Citi et al) will be responsible for providing the new cards to their customers, at a cost of $5 to $10 each, according to the National Retail Federation. (This is no small expense, as it's estimated there are 1.2 billion active credit cards extant in the U.S.)

The new chip cards will also require new payment terminals at the retail point of sale (POS), at a cost of about $1,000 each. By most accounts, the nation's retailers will be responsible for those costs at millions of cash registers.

Thus, the payment networks (Visa et al) are apparently not on the hook for the new cards or the new terminals. Further, the networks have decreed that after October, 2015, banks or retailers still using the old vulnerable magnetic swipe cards will pay for any hacker-theft charges that arise from the old cards. The Target data theft case alone could cost about $1 billion.

The payment networks themselves also do not appear particularly vulnerable to future sea changes involving mobile transactions. The networks, which make their money from transactions regardless of payment platform, are collaborating with major mobile service providers -- AT&T (NYSE:T), Verizon (NYSE:VZ), T-Mobile (NASDAQ:TMUS) -- in those companies' efforts to foster mobile payments at retail POS. The networks are also embedded into online transactions by Google, Apple, etc.

Even if the payment networks are not responsible for the new chip cards and terminal costs, or for the risks of card hacker fraud, or the threat of technological obsolescence, there is still the matter of all of that credit card debt out there.

But the credit card industry - including the payment networks - has managed to offload much of that risk to the derivatives market via asset-backed securities (ABS). A vast galaxy of credit card receivables estimated by Fitch Ratings to total $251 billion has been pooled into ABS portfolios that originated with big banks and the payments networks, but that now are in the hands of investors.

If (or when?) fresh derivatives bubbles form like those that forced the 2008 global financial meltdown, common sense says there could be adverse fallout for credit card ABS. One is reminded of proposals from various scientists to deal with the earth's growing radioactive waste by trying to shoot it into outer space - sooner or later, you just know such a mountain of toxic material will yield to gravitational pull and fall back to earth with a very loud thud.

But again, the payment networks have managed to lay off their ABS risk onto willing investors.

The payment networks make much of their money from per-transaction charges and interchange fees that range from 1 to 5% of each charge. Thus it is easy to see the networks are benefiting now from higher volume stemming from credit expansion in the current economy - Americans are using their credit cards again at the highest level since the recession. If inflation grows, the networks will make even more money.

The four major payment networks - Visa, American Express, MasterCard and Discover - are all components of the Barron's 400 Index, which adheres to a growth-at-a-reasonable price (GARP) selection strategy.

In fact, they all fit the fundamental growth and value requirements of the Barron's 400 (B400) with room to spare.

These four payment stocks have an average forward PE of 16.69 vs. 20.2 for the B400 overall; an average price/book ratio of 6.08 vs. the index's 6.2; and an outsized average operating margin of 48.82% vs. the index's 23%. Only in ROE (TTM) do they appear a bit on the light side, at 28.75% vs. the index's 34.1%.

Also on the valuation front, Thomson Reuters/Verus assigns American Express a trailing PE of 17.4, which is at a 30% discount to the S&P 500's 24.9; and a forward PE of 15.6, a 20% discount to the S&P's 19.4.

Discover's trailing PE of 10.8 is at a 57% discount to the S&P, and its forward PE of 10.4 is at a 46% discount to the S&P's 19.4.

MasterCard's and Visa's forward and trailing PE's relative to the S&P 500 are not as strong, but each has a hefty 12-month mean price target according to the Thomson Reuters/Verus analyst consensus.

MasterCard's 12-month mean price target of $89.60 is a 19.6% increase over the current share price as of February 10; Visa's mean target of $256 is a 16.9% increase; Discover's $61.60 mean target is a 14.1% increase; and American Express's $94 mean target is 9.7% increase.

In addition to enjoying shrinking delinquency ratios and expanding consumer credit, all four companies are capturing incremental digital, mobile and prepaid card growth that should justify current price targets at the minimum.

BOTTOM LINE: V, AXP, MA, DFS appear to offer significant value relative to their current and future prospects. Their business model has plenty of blue sky and elbow room, they enjoy enviable insulation from expense risk, and they are beneficiaries of an improving economy or future higher inflation or both.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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