July 16, 2007

The Fool on Discovery Financial

In May 2006, MasterCard's (NYSE: MA) IPO was greeted with a lukewarm response from market pundits. Critics almost universally viewed the IPO as a way for the banks to distance themselves from antitrust and other litigation, particularly from Morgan Stanley's (NYSE: MS) Discover Card and American Express (NYSE: AXP).

Concerns were so overwhelming that the IPO price was dropped 10% to just $39 per share. Two days after the IPO, MasterCard shares traded at $46, but the sentiment was still negative. I liked the shares in the mid-$40s and recommended them to subscribers of Motley Fool Inside Value.

More than a year later, MasterCard is now trading around $170 on the back of a phenomenal increase in profitability and the expectation that management can achieve its targeted earnings-per-share growth rate of 15% to 20%.

On July 2, Discover Financial Services (NYSE: DFS) opened at $28.55, but as often happens with spinoffs, it would appear that many shareholders are ditching their shares because they represent a much smaller holding than their Morgan Stanley position. The shares now trade down 5% (around $27), having been as low as $25 earlier in the week.

An opportunity?
Foolish colleague Emil Lee wrote earlier this week that Discover was a "solid buy." Emil's argument was sound, and I don't want to tread the same ground. Rather, because MasterCard has been our biggest gainer at Inside Value, I thought it would be worthwhile to examine Discover's recent offering in light of what MasterCard looked like last summer.

And so let's get one thing straight: Discover shares aren't likely to outdo MasterCard's. Discover Financial does not have the same leverage because of its much smaller market share, and its brand hardly registers outside North America.

In the first couple of years, spinoffs typically see increased expenses and capital expenditures while the company establishes itself and manages the business without interference from a corporate parent. On the plus side, the standalone company now must answer to its own shareholders, so we can expect capital allocation decisions that benefit shareholders rather than the corporate parent. The independent entity also has an easier time making alliances with other banks.

Discover is, by far, the smallest of the credit card companies, and it doesn't have the same financial clout as the Big Three. Nevertheless, even the smallest card will benefit from the increasing consumer trend away from cash toward electronic payments. In addition, legal rulings against Visa and MasterCard's restrictive practices have opened up the market for Discover, and it can expect a significant cash settlement from Visa and MasterCard when the legal issues are resolved.

The Foolish bottom line
I expect Discover Financial Services to gradually improve revenue growth from an anemic 5% over the past three years to around 7% to 8%. Profit margins should also improve as the company gets a hold of its expenses.

The upshot, then, is that I can see these shares being 15% to 25% undervalued -- not quite the MasterCard-sized opportunity of 2006, but not to be sniffed at, either.

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