Discover Financial Services Provides Good Entry Into Financials Allocation

| About: Discover Financial (DFS)

By Carson Ko

Discover Financial Services (DFS) is one of the two closed loop credit card issuers in the United States since 1986. The company payment services division also operates payment services such as the PULSE network, Diners Club and credit, debit and prepaid cards issued by third parties such as Wal-Mart. While Discover's operation is not as big as its rival American Express (AXP), it is no doubt an important player with a stable and profitable position in the industry.

Price depressed due to current climate

For the last few years, the credit card industry has been suffering due to the bursting of the mortgage bubble, over-spending and the unemployment rate. With WaMu gone the way of the dodo bird and Bank of America (BAC) still in a mess, investors are avoiding financials across the board. Granted, credit card write-off rates have been high through the last few years. (charge-offs, write-offs, and delinquency rates are the measure of loan performance and ultimately determine loan loss and eat into company's cash flow). However, an article in Chicago Business shows that charge-off rates have been trending lower since last year. This should be a wakeup call to take another look at some of the credit card companies.

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Earnings and growth

Discover has been trading below 10x earnings since the March of 2011 and has been beating wall street analyst estimates for the last five quarters. The stock's earnings per share has also more than doubled since May 2011. Furthermore, recent data shows that credit card charge-offs and delinquency rates have continued to decline for not only DFS but all the other major U.S. lenders. The company's coming Thursday (9/22) earnings conference call should bring positive news and data. With peak write-offs behind them, Discover should enjoy higher margins in the near future.

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Balance Sheet health

The company's balance sheet has been relatively stable for the last several years. They did have to consolidate the trusts used in securitization activities in their 2010 balance sheet with little to no goodwill and PP&E. Furthermore, Discover has been on the low end of debt-to-equity ratios when compared to the rest of the industry. The capital structure has proven itself in the past few years that the company can weather through an unstable economic environment.

Regulatory concerns

There have been talks of regulating fees charged to merchants. If the merchants’ fees decrease substantially, it is going to lead to lower revenue for the whole credit card industry. It is still too early to measure how much and how soon this impact will change the dynamic, especially for companies like Visa, MasterCard and American Express which have a big part of their revenue linked to fees receivable. However, unlike American Express, which earns more than 80% of revenue from fees, Discover only earns 60% of its revenues from loan receivables. This should provide relative shelter to these concerns.


In recent weeks, the financial industry has declined on weaker economic news and problems in Europe. With volatility increasing, i.e. Bank of America, it is hard to put down another dollar in the financials. The more stable and financially sound companies, like Discover, give investors the opportunity to increase positions ahead of a sector-wide rebound. DFS is currently trading at 8.9 times earnings with between 20%-25% upside potential.

Disclosure: I am long DFS.

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