November 27, 2007

Is Discover a Deal?

From the Fool:

When shares of Motley Fool Inside Value recommendation Discover (NYSE: DFS) traded at $25, I described them as a "solid buy." If shares kept sliding, I warned, I might be forced to pull out my wallet. With Discover now marked down below $17 as investors flee the financial sector, it's a good time to take another look.

The sliding spinoff
Why have Discover's shares performed so poorly? Besides the obvious credit-crunch problems roiling the financial sector, I believe the company's spinoff status is also partly to blame. Like the fortune cookie at the end of a Chinese dinner, spinoffs are often cast aside because they're a free giveaway at the end of dinner, not the main course.

When Morgan Stanley (NYSE: MS) spun off shares of Discover Financial, it was easy for investors to overlook the company. After all, Morgan Stanley is a blue-chip investment bank, while Discover is only the sixth-largest credit card issuer, and the fourth-largest credit card network.

In addition, Morgan Stanley distributed one share of Discover for every two shares of Morgan Stanley investors owned. At the time of the spinoff, Morgan Stanley shares were trading at about $75, and Discover at $30.

Given the 2-for-1 ratio, Morgan Stanley investors would've received $15 worth of Discover stock for every $75 in Morgan Stanley stock they owned, or a mere 20% of the value. As a result, it would've been easy for investors to not even care about their Discover shares, and simply dump them.

As Discover shares kept sliding, it's likely that increasing numbers of disinterested shareholders, handed shares that they never chose to own, joined the selling frenzy.

Credit card comparables
Capital One (NYSE: COF), American Express (NYSE: AXP), and MasterCard (NYSE: MA) currently trade at seven, 14, and 26 times forward earnings estimates. Why the discrepancy between Capital One's multiple and those of its larger rivals? It's largely a matter of credit risk.

MasterCard, as a credit card network, takes a small fee from every transaction and bears virtually no credit risk. Thus, it trades at a rich multiple. American Express' customers are usually the ultra-rich, and the company also owns its own credit card network, in addition to being a credit card issuer. As a result, the company isn't as prone to credit risk. In fact, even if credit losses had doubled last quarter, American Express still would have made a profit.

On the other hand, Capital One, as a credit card issuer that doesn't own its own network, makes most of its money from what it earns in interest payments from credit card holders, minus its cost of funds and credit losses.

Thus, it's much more exposed to credit risk than a credit card network like MasterCard or a network/issuer like American Express. As a result, Capital One has taken a series of credit losses (partly because of a discontinued mortgage segment), and its shares trade at a much lower multiple.

What price Discover?
In that framework, what would be a fair price for Discover? Unlike Capital One, Discover owns its own credit card network, but it lacks the affluent client base of American Express. It also has a much smaller market share than MasterCard. On a relative basis, it should arguably trade at a premium to Capital One, but at a discount to American Express or Mastercard.

At 10 times forward earnings (equating to a 10% earnings yield), Discover seems fairly priced -- attractive, even. Although shares have fallen on consumer credit fears, the average FICO score on new Discover accounts is a respectable 734. So while credit losses will almost certainly increase next year, it seems that Discover has remained disciplined in its credit underwriting.

Although Discover will be fighting headwinds as credit losses increase and the economy swoons, at an estimated 10% earnings yield, it seems to be paying shareholders enough to assume its consumer credit risk. As a result, investors with a two-to-four-year outlook and a stomach for volatility could do very well if they make room in their portfolios for Discover.

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