Discover Financial Services (DFS) has been one of the hottest financial stocks recently with its surge of 11.3% over the last month. Much of the negative crash-and-burn sentiments surrounding Discover have since dissipated with 17 of the last 18 revision to EPS estimates going up for a net change of 3.4%. The company is now rated a "buy" - roughly where American Express is (AXP). Through a multiples analysis and DCF model, I find that Discover is more undervalued.
From a multiples perspective, Discover is the cheaper of the two. It trades at a respective 6.5x and 7.9x past and forward earnings while Amex trades at a respective 12.6x an 11.9x past and forward earnings. With Visa (V) at 24x past earnings, both Discover and Amex have upward potential in the multiples, particularly within the context of a sooner-than-expected recovery. Not surprisingly, these two companies make exaggerated swings to the domestic economy with their high betas. Investors confident about a full recovery in 2012 would greatly benefit from opening a long position.
At the third quarter earnings call, Discover's CEO, David Nelms, noted some highlights:
"Earlier today, we reported fourth quarter net income of $513 million or $0.95 per share, driven by continued improvements in credit and receivables growth in all products. Our strong results and positive outlook for Discover led us to announce a 67% increase in our dividend and to continue to execute on our share repurchase program…
Discover card sales volume grew 8% compared to the prior year. The strong sales performance continues to include higher spending from the revolver segment of our portfolio, helping us to grow card receivables, $47 billion. Our continued success in growing sales and receivables reflects greater effectiveness in marketing programs, cash rewards leadership and expanded merchant acceptance, all of which contribute to increases in profitable growth. One example of this is our recently announced program with amazon.com, in which Discover card members can pay directly with cashback bonus at this site, as well as earn double rewards on their purchases until the end of the year. Since we launched the program in October, we have seen a significant increase in card member purchases at Amazon".
NIM is proving resilient and with CDs maturing in 2012, Discover is in a strong position to outperform its peers. The first two weeks of December were characterized by strength in debit activity and transaction counts. Organic student loan growth is expected to total $1.2B in 2012. In light of all the negativity that surrounds financials, investors stand to benefit from high risk-adjusted returns.
Consensus estimates for Discover's EPS forecast that it will decline by 17.7% to $3.34 in 2012, hold flat in 2013, and then grow by 6.6% in 2014. Assuming a multiple of 11x and a conservative 2013 EPS of $3.29, the rough intrinsic value of the stock is $36.19, implying 36.8% upside. Even if the multiple were to be 8x and 2013 EPS turns out to be 6.9% below consensus, the stock would only fall by -5.9%. The favorable risk/reward warrants a "buy".
I have more reservations when it comes to Amex. In the third quarter, the company experienced average y-o-y loan growth and improving loss rates. Margin pressures at banks will limit investments in their card business to the benefit of Amex. Management has noted improving trends and the mobile payments business is a catalyst that the market has yet to fully appreciate given macro woes. With that said, I am concerned about the aggressiveness of capital allocation and margins given constant emphasis on Fed approval.
Consensus estimates for Amex's EPS are that it will grow by 21.8% to $4.08 in 2011 and then by 2.5% and 11.2% in the following two years. Assuming a multiple of 12.5x and a conservative 2012 EPS of $4.12, the rough intrinsic value of the stock is $51.50, implying 4.2% upside. Modeling a 11.55% CAGR for EPS over the next three years and then discounting backwards at a WACC of 9% yields a figure of $59.12.