AmEx's Pain Likely Discover's Gain

If you are a merchant, accepting credit and debit cards is a must. After all, more and more Americans are paying with plastic nowadays. As a merchant, you can get free decals from Discover (DFS), AmEx (AXP) or Visa (V). But depending who you order your decal from, the order of the networks on the decal might be different. Can you guess where these decals they come from?

The first one is from Discover, the second is from AmEx and the last one is from Visa. Each network purposefully put their main competitor last on the decal, and of course they all put their own name first. These simple decals tell us a lot about who each company thinks its primary competitions are.

• Discover thinks AmEX is its no. 1 Competition
• AmEX thinks Discover is its no. 1 Competition
• Visa thinks MasterCard is its no. 1 Competition

The reasons are quite simple:  American Express and Discover have about 28% the US credit Card transaction volume, Visa and MasterCard (MA) have the remaining 72% or so. The latter two card brands are issued by more than 6,000 banks in the US. As card issuers, AmEx and Discover using their own networks are far more successful at signing up new clients than Visa and MasterCard issuers. As you can see, these two companies (DFS and AXP) get 28% of the total credit card sales volume, the other 6,000 or so banks together share the remaining 72%. 

American Express had an analyst meeting on Wednesday at which management tried to explain the sharp rise in delinquency and charge-offs in the most recent quarter. From the presentation, 2006 vintages are approaching a 10% annualized charge-off rate. 2005 and 2007 vintages are doing slightly better at around 8%, with overall charge-offs at 5.3% in the second quarter. 5.3% is not a bad number, but when you compare that number to same period last year of 2.9%, something is horribly wrong here. Amex's charge-offs rose at a rate of 83% YoY and continue rising. If you take a look at Discover's charge-off rate of 4.99% vs. 3.97% last year, that's at a comparatively much better rate of only a 26% increase YoY.

Of course, management placed most of blames on the economy, whining about how bad things are getting. As I wrote in an earlier article, this is really more of an AmEx specific problem, as the company handed out larger credit lines to its card members than they should have in order to outgrow the industry in recent years.

AmEx will continue to have more trouble ahead. With the global economy slowing down, AmEx's international segment could experience the same problems it's facing domestically. With charge-offs in recent vintages approaching 10%, the underwriting standards at AmEx in recent years have been problematic. 10% charge-off rates are typically associated with subprime credit card underwriting. Just ask Target (TGT). Its charge-off rates are approaching 10% also.  I hate to see what's happening to a great business like AmEx as Ken Chenault ran it into the ground.

The likely winner from AmEx's self-inflicted wounds is Discover. Discover has been very prudent in its underwriting in recent years. It skillfully scaled back marketing from Florida, California and other housing bubble areas since 2004. As AmEx is busy scaling back credit card limits, it can potentially upset lots of clients who may want to switch to another credit card lender. Discover is in a prime position to pick up these customers. While many financial institutions are desperately in need of capital, Discover has $2-3 billion dollars in extra capital it can deploy to pick up market share from its struggling rival. 

Calyon Securities analyst Craig Mauer has been mindlessly praising AmEx for its hyper growth in recent years, while trash-talked Discover for its slower growth; he will be shocked to discover this simple truth: underwriting standards do matter.

It pays to be a contrarian. Discover may have "underperformed" in the last credit card cycle, but it will likely to be the winner during the next one.

Disclosure: I am long DFS and have no positions in any other companies mentioned.

Comments

[galen c little:]

So often these writers waste my time.

2008 Aug 11 05:00 AM

[globalHOBBIT:]

Why was this article no surprise to me when I came to the disclosure at the end only to see: [long: DFS]. Nothing like a fair and balanced credit report. Looking for a job at Wamu, LEH or MER as all honest analyst positions at Bear Sterns and CFC for unbiased truth telling are full up. DFS is in worse shape than even Capital One/COF as very well outlined in Morningstar's reports.

2008 Aug 11 06:11 AM

[mrbill for V:]

Frank: Interesting viewpoint, "globalhobbit" perhaps you should become a Morningstar Premium Member. DFS & COF are rated 5 stars each and yes they will never become Visa. However there is room for all and each has a different business model. Should there be only one car company?

2008 Aug 11 06:37 AM

[globalHOBBIT:]

As it so happens I am a Morningstar Premium Member for many years now and Morningstar thesis and valuations for AXP and DFS in the 'Analyst Report Summary' were both written by Michael Kon. Yes they both get 5 stars for very different reasons. As a M* prem member you should read M Kon's analysis to see why DFS won't be in as good a place as AXP after this credit crunch is over. Goldman's analyst are of the same opinion as Morningstar on AXP and DFS. DFS is mainly a North American operation which limits its growth prospects vis-a-vis AXP's worldwide operations, especially in emerging markets where AXP is far outspending DFS in developing new customers. I like just facts no emotions in stock choosing, commodities, well that's different.

2008 Aug 11 07:22 AM

[tilut:]

I do not know if DFS will take advantage of AXP problems , but I am sure they will do great in the future and that DFS has more possibilities for growth than AXP which is already so big.With respect to analysis and analysts doing them , I say their are generally useless and mislead investors.You all know that analysts change their opinion and recommandations as easily and often as Jim Cramer. DFS will prove all them wrong in the next quarters and years.DFS rocks .

2008 Aug 11 07:50 AM

[User 172125:]

Yes- Frank I hear DFS is on fire! They added 70 new accounts last month!!! They are now accepted at Ralph’s ribs in Tulsa!!!

Also- since you didn't want to come clean about who you are I am going to have to pull the cover. Anyone that has been reading Visa and MasterCard posts for some time will recognize the writing style of Frank Rong as that of GreenCapital (who then went on to become MATRADER). Notice that MA Trader stopped posting on his blog at the same time Frank Rong first appeared. Notice that GreenCapital stopped posting on Seeking Alpha when he re-invented himself as MA TRADER.

I repeatedly attempted to communicate with Ma/green cap- and asked him why he was 100% anonymous if he was an author of an investing blog. He never gave me the answer but continued to repeat that he would 'let me know who he was'. After losing the MA/V battle we now have Mr. Rong. , who by the way- ALSO goes by yet another handle called starting with 'MOJO'. I can't believe I was the only one to pick this up yet....

I noticed it when arguing with him over AXP/DFS vs. V. I could see the same semi-broken English and use of slang 'cherry' valuations. The only thing 'Frank' hasn't done is the old DFS will 'spit-chew-crush-etc' (which was a green cap trademark). BUT- the speech pattern is the same.

So- either Frank is helping to developing content for Seeking Alpha and is just taking the contra side of the V trade as it makes for solid traffic- or he is actually delusional enough to believe that DFS is a solid company (either scenario being sad- but both being deceitful).

Frank- give it up- you are green cap/ma trader. I see your cards.
For anyone else that finds this amusing go back to Green Cap and you will see the same syntax and speech patterns.

2008 Aug 11 09:22 AM

[Frank Rong1:]

Steve,

I have nothing to hide, I am not greencapital, nor MA trader

2008 Aug 11 10:21 AM

[Frank Rong1:]

Morningstar is sure better than most of stock analysts, but I am not a fan of morningstar. they cover too many stocks and try to be expert on everything. Many of their research are flawed.

2008 Aug 11 10:24 AM

[User 208427:]

BTW, Amex cards are now issued by many banks...

2008 Aug 11 11:24 AM

[warelf:]

Both DFS & AXP will do very well in the long run and I like both companies, but looking at short term charge-off rates and concluding that DFS is the better investment is plain "Rong=headed" Way too myopic to be considered decent analysis. The key difference between the two is that Amex has far more clout and can charge higher discount rates to merchants. It consequently has a much higher ratio of fee income to loan interest income. It will always be a much better business than DFS. DFS has a much higher reliance on securitizations than AXP for funding.


Charge=offs through the cycle

2008 Aug 11 03:29 PM

[User 172125:]

Frank- If you are not GreenCap then you have a verbal twin- you sound and post just like him....

Anyway- moving on- DFS is growing by leaps and bounds I hear they just signed up Harry's used cars in Nebraska- and did some viral marketing and linked up with Maude's stereo shop next door!

On a serious note- as long as default rates are increasing there is no reason to let your money float for another year when you can catch momentum on V. For example, just take a look at the charts over the last couple of months- plenty of action- but with a safety net. If all you did was trade on dips and rallies and took profits every on every 5 dollar move you could have done quite well for yourself.

DFS will get a little bump from the MA/V settelement action. The lawsuit is going to trial in September. I still think this will settle this month (pre-trial). Now if that happens DFS will get a nice little bump. Is that the 'trick up the sleeve' frank- bullish on DFS because you think they will have a nice little bump this month??

Frank- Let's say you are not Green Cap- what are a few of the other stocks you like right now?

2008 Aug 11 08:17 PM

[User 172125:]

warelf- "rong headed" .....I'm laughing my ass off right now...

2008 Aug 11 08:20 PM

[User 172125:]

Frank- One other thing that doesn't make sense about you... I read your bio and you said that you are a fan of Warren Buffet. Warren (Berkshire) is Amex's largest shareholder yet you are playing DFS. That seems a bit contradictory?

2008 Aug 11 10:33 PM

[BAC PL:]

Frank -- We get that you love DFS. When did you get in (hopefully not last year!), and what's your prediction for 6 and 12 months for DFS?

2008 Aug 13 07:11 AM

[Konst:]

very tenuous attempt at establishing a cause and effect relationship, i.e. that's some bullshit assumptive reasoning. disclosure: long DFS

2008 Aug 14 12:29 AM

[j82:]

I agree with the few DFS fans. It's easy to jump on the V/MA/AXP bandwagon because they have already established solid merchant acceptance and growth. You have to understand that DFS has always been owned by another company so their hands have always been some what tied.
Their first attempt with the Goldfish Card in the UK failed but like any good business does, they learn from their mistakes. DFS bought Diner's Club who has a network in over 180 countries. Soon, and DFS cardmember can use their card in over 180 countries. Global Merchant acceptance issue solved. In the U.S., acceptance is over 4.5 million merchants and they recently partnered with many acqusition companies, including the top 10, and are adding thousands of merchants a month(this has been happening the last several months).

Was anyone else aware that out of the top 100 retailers in America, DFS is accepted at 98? That is more than V/MA/or AXP believe it or not. Now that DFS is an independent company, they can make their own decisions and be able to focus on their own growhth 100% So yes, be happy to own DFS shares for the long term of course!

2008 Aug 14 06:52 PM