Is Discover Financial A Value Investment?

| About: Discover Financial (DFS)

Discover Financial Services (NYSE:DFS) has long been a contrarian investors' favorite because its revenue has been growing, even as rival American Express (NYSE:AXP) has struggled to retain market share. Despite that, Discover also displays some of the attributes of a value investment.

The most intriguing thing about Discover in recent years has been its revenue growth. In November 2012, Discover reported a TTM revenue of $7.653 billion that grew to $8.224 billion in December 2013, $8.477 billion in December 2014, and 8.739 billion in December 2015. That's pretty good when compared to American Express, which is losing revenue.

Amex had a TTM revenue of $34.19 billion in December 2014 that fell to $32.82 billion in December 2015. Discover has proved that it is capable of expansion in a shrinking credit card industry; the number of Discover card holders increased from 36 million in 2000 to 43 million in 2014, according to Statista. During the same period, the number of American Express card holders grew from 23 million to 38 million.

These numbers show us that American Express is still making a lot more money from its cards, but it is struggling to keep the cash flow up. Discover is slowly and steadily growing, which justifies its business model of offering a basic credit card.

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Discover is the Card for Today

One reason why the number of Discover and Amex card holders has increased is that the issuance of some other cards has dropped. For example, there were 76 million oil company credit cards in the U.S. in 2000 and 28 million in 2014. The number of store credit cards in the U.S. fell from 114 million in 2000 to 103 million in 2014.

Discover's policy of avoiding exclusive arrangements, such as the one that American Express had with Costco Wholesale (NASDAQ:COST), has paid off. Its concentration on customer service has made Discover the most popular credit card brand with customers, Fortune reported. Last year, J.D. Power declared Discover America's favorite credit card after surveying 1,000 customers. American Express was number two for the first time.

Discover earned that rating, even though it is still not accepted by many retailers. Much like American Express, Discover is shunned by small merchants and others because of the high fees it charges to retailers. Another drawback to Discover is that it is not widely accepted outside the U.S.

This makes Discover a niche player, but it is a very big niche and a growing niche. One huge opportunity that Discover has taken advantage of is payment apps. It is accepted on both Android Pay and Apple Pay; unfortunately, those apps are still not accepted by many of America's largest retailers, including Walmart (NYSE:WMT), Costco, and the Kroger (NYSE:KR) supermarkets.

Is Discover a Good Investment?

Okay, so Discover is growing and its business model is paying off, but is it a good investment? The answer for the moment is yes.

On Dec. 31, 2015, Discover delivered some glowing financial numbers, including a 5.128 earnings per share number, a net income of $2.297 billion, a profit margin of 22.68%, a free cash flow of $995 million, $9.572 billion in cash and short-term investments, $1.302 billion in cash from financing, and $3.854 billion in cash from operations.

If you like companies with float, you should like Discover because it has a lot of it. Discover generates a lot of cash, and more importantly, it keeps the cash. It also pays out for investors as well. Discover paid a dividend of 28¢ and offered a dividend yield of 2.21% on Feb. 2, 2016.

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More importantly, Discover's dividend has been growing in recent years. On Feb. 4, 2014, it paid a dividend of 20¢ that grew to 24¢ on Feb. 3, 2015. So if you're looking for a value investment that pays a dividend, take a look at Discover.

Growth stock investors might like Discover as well; it offered a 21.51% return on equity on March 18, 2016. Value investors should note that Discover is undervalued; it had an enterprise value of $36.22 billion and a market capitalization of $20.95 billion on March 18, 2016.

My take is that Discover is a good buy and hold stock because of the low price and steady growth. The float will enable it to retain value, while it is poised for some growth.

The Potential Threats to Discover's Future

The only real threats to Discover's business are hypothetical oness, such as the growing popularity of digital wallets, such as PayPal Holdings Inc. (NASDAQ:PYPL). PayPal is an interesting threat to Discover because it is a digital wallet that also offers lines of credit and loans. If it were to start offering consumer credit, PayPal could become a major threat to credit card companies.

On the other hand, peer-to-peer lenders such as Lending Club (NYSE:LC) and the privately-held Prosper are not a direct threat to credit card companies. These companies are niche players that make very specific loans to certain individuals and not consumer products for a mass audience.

My take is that Discover will maintain its market share and experience modest growth for the foreseeable future because of its strong brand. The brand should attract new customers, while the growing popularity of digital wallet transactions should increase Discover's volume of transactions.

If you're looking for a credit card to buy and hold for the long term, Discover looks like it. This company has a strong brand, pays good dividends, and generates a lot of cash, making it a great play in a hard-to-understand industry.

Disclosure: the writer of this piece owns shares of PayPal.