Discover Financial: The Free Cash Flow Monster

| About: Discover Financial (DFS)

Summary

Discover is a cheap way to play the consumer lending market.

High Return on Equity (ROE) and Free Cash Flow (FCF) lead to large returns of capital.

Trades at a substantial discount to the market.

I believe Discover Financial Services (NYSE:DFS) is undervalued trading at a P/E of 10.5 vs. the current market multiple of 25. Warren Buffett said "price is what you pay, value is what you get." With Discover I believe investors are getting a large value at a low price due to the large spread they can earn on their various consumer lending products. Discover's largest product is their credit card, but they also dabble in other consumer markets like consumer loans and student loans. I believe that Discover offers quite a bit of upside with many ways to win without much downside.

Ways to Win

It's Cheap: Discover is trading at a cheap multiple. With the market trading at 25x earnings and Discover trading at 10.5x earnings it is trading at a very large discount. I believe the discount is due to the overhang that continues to dog financial stocks due to the financial crisis of 2008. While I agree that some discount to the market is warranted I believe this is too large of a discount.

Consolidation: The credit card market is ripe for consolidation. Basically there are 4 primary networks in the United States (Visa, MasterCard, American Express & Discover). Only two of these companies take market risk (DFS & AMEX). The other two (V & MA) operate networks, but take no credit risk. They basically operate as toll booths to the credit card issuers like Citi, Chase, Bank of America, Capital One, etc. I don't want to get into the specifics to the advantages or disadvantages in this article, but I could see one of the issuers wanting their own network of distribution so they wouldn't need to rely on V or MA. I could also see an AMEX/Discover merger or even somebody outside the US such as China Union Pay or Japan Credit Bureau buying Discover to enter the US market. With a $22.5 billion market cap, Discover is not so huge that it couldn't get swallowed up by a large player who wanted their own credit card network operation.

Market Share: As you can see from the below chart, Discover is a fairly small network. Visa & MasterCard control the vast majority of the market, but if Discover can profitably grow their market share they could have a long runway of growth for many years.

Chart courtesy of The Nilson Report

New Products: In 2007 Discover had roughly $53 billion in outstanding loans. Almost 100% was in credit card volume. In 2015 this number had grown to $72 billion in outstanding loans, but roughly $57 billion is credit card and the other $15 billion (21%) is in consumer and student loans. If they can continue growing these new products obviously revenues and profits will continue to grow. They could also potentially enter other consumer unsecured or even secured markets given their strong understanding of risk management and the drivers of risk in the consumer lending space.

Overall Credit Growth: The US payment cards market grew at a CAGR from 4.5% from 2012 to 2014 and is expected to grow at a CAGR of 1.3% over the years 2015-2020. Discover had a loan growth CAGR of 6% from 2010 to 2015 vs. 2% for large banks showing that they are growing more quickly and taking market share from large banks. For the last quarter (Q2 '16) they reported loan growth of 4% Y/Y ($2.9 billion). After all, American consumers do love to buy stuff.

Capital Allocation: Discover plans on buying back $2.5 billion of shares over the next 15 months. This is greater than 10% of the company at the current price of $56.50. They also pay a decent dividend of $0.30 per quarter representing a yield of 2.12%.

Ways to Lose:

Increasing charge-offs: Discover reported a charge off rate of 2.27% in the last quarter (Q2 '16). This is below the industry average of 3.00% and is well below the historical average seen of ~4%. While it was an extreme time, many lenders saw charge-offs on credit cards rise above 10% during the financial crisis. I will mention that Discover has historically had lower charge-offs than average as can be seen by the below chart.

Bank

Q1'12

Q2'12

Q3'12

Q4'12

Q1'13

Q2'13

Q3'13

Q4'13

Q1'14

Q2'14

Citigroup

5.36%

4.82%

4.63%

4.37%

4.39%

4.24%

3.88%

3.76%

4.06%

4.04%

U.S. Bancorp

3.75%

3.81%

3.80%

3.67%

3.68%

4.02%

3.62%

3.61%

3.77%

3.78%

Wells Fargo

4.37%

4.35%

3.68%

3.72%

3.90%

3.90%

3.31%

3.40%

3.52%

3.19%

Capital One

4.14%

3.13%

3.22%

4.32%

4.45%

4.36%

3.78%

3.98%

4.02%

3.56%

Bank of America

5.45%

5.08%

4.51%

4.14%

4.12%

4.07%

3.49%

3.23%

3.14%

2.93%

JPMorgan

4.34%

4.30%

3.59%

3.52%

3.50%

3.30%

2.88%

2.87%

2.88%

2.86%

Discover

3.07%

2.79%

2.43%

2.31%

2.36%

2.34%

2.05%

2.09%

2.32%

2.33%

American Express

2.30%

2.20%

1.90%

2.00%

1.90%

2.00%

1.70%

1.60%

1.70%

1.60%

Chart from Forbes.

Competitive Industry: The consumer lending space is very competitive and the Fintech industry is growing and there are new products coming out all the time. This could be very disruptive to the consumer lending industry.

Discover Income Statement:

5 yr.

8 yr.

Discover

2007

2008

2009

2010

2011

2012

2013

2014

2015

CAGR

CAGR

Revenues

4,738

5,669

6,734

6,658

7,065

7,653

8,224

8,477

8,739

6%

8%

Operating Income

1,526

1,658

2,121

1,269

3,511

3,753

3,944

3,694

3,612

23%

11%

Net Income

589

928

1,276

765

2,227

2,345

2,470

2,323

2,297

25%

19%

Shares

479

473

508

549

543

520

487

463

438

-4%

-1%

Earnings per Share

1.23

1.92

2.38

1.22

4.06

4.46

4.96

4.9

5.13

33%

20%

Free Cash Flow

1,920

4,411

3,544

3,818

3,498

2,897

3,286

3,681

3,686

-1%

8%

Dividends

0.06

0.24

0.12

0.08

0.20

0.40

0.60

0.92

1.08

68%

44%

Chart compiled by author using data from Morningstar.

The income statement shows how well the company has been able to grow revenues, operating income and net income over the years. They did have a blip in 2010 following the financial crisis when people were getting laid off and had trouble paying their bills, but they have been extremely stable over the last 3+ years. Even if net income does start decreasing due to increased charge-offs or consumers decreasing their use of credit cards the company already has shares down to 411 million as of Q2 '16 and is projected to buyback roughly 10%+ of the outstanding float at the current price of $56.50 (announced $2.5 billion buyback plan). This means at the current price of $56.50 the company could buyback roughly 44 million shares which would bring the share count down from the current 411 million down to ~367 shares. So even if the company has net income that averages the last 5 years of $2.33 billion their EPS would rise above $6.25 per share ($2.3 billion in earnings / 367 million shares). Put a 10.5 multiple on $6.25 and you get a price of $65 or an 18% increase from the current price of $55.5. If Mr. Market decides to value it with a higher multiple, say 12x, which is still half the current market multiple, you get a price of $75 and a 35% return plus a ~2% dividend yield.

Free Cash Flow:

Discover is a free cash flow monster. They have very low capital requirements being in the lending business and with free cash flow of over $3.5 billion in each of the last two years they can continue to buyback shares and increase dividends. Over the last 9 years from 2007 to 2015 their worst year of free cash flow generation was $1.9 billion in 2007. This is still enough to easily cover their yearly dividend outlays of ~$500 million (411 million shares * $1.20 per share). With this coverage ratio of almost 4x in their worst year shows that Discover should easily be able to continue to generously return capital to shareholders through dividends and buybacks. With free cash flow of $3.8 billion over the last 12 months, this represents a 17% FCF yield based upon their $22.5 billion market cap and a FCF yield of 10.5% FCF yield based upon their enterprise value of $36.1 billion.

Bottom Line:

I believe the financial crisis overhang has given consumers a great opportunity to buy Discover at a very reasonable price. I don't know if Mr. Market will ever reprice this stock closer to a market multiple and given the scare all financial stocks were under in 2008 I believe it should trade at somewhat of a discount to the market. But based upon Discover's high ROE, FCF generation and low market multiple I see many ways to win buying this company and not many ways to lose money in this stock unless there is another financial crisis. And if there is another financial crisis like 2008 I'm not sure any stock will hold up. As always, do your own homework, but this author puts a strong buy stamp on Discover Financial Services.

Disclosure: I am/we are long DFS.

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.