Discover Financial: Growth in New Products

by Zach Scheidt

Shares of Discover Financial Services (NYSE: DFS) offer a tremendous value for investors as the company expands its product offering and capitalizes on its growing customer base.

The company has a number of new initiatives in place for 2013 that should drive sales and profit growth. As a result, I expect investors to realize an attractive profit as shares trade higher, while simultaneously collecting healthy dividend payments.

Investors should consider this stock for stable growth with minimal risk over the next year. Discover Financial is trading at a very attractive valuation, especially given the company's growth initiatives.

A Healthy Client Base

Over the past decade, Discover Financial has worked hard to build its customer base, despite facing significant competition from primary card issuers Visa and MasterCard. In the United States, Discover can now boast that it has a presence in one of every four households.

One of the ways the company has been able to actively solicit new clients is through the cashback program. Depending on the type of purchase, Discover cardholders receive a percentage of each transaction back as a redeemable cash credit.

Discover was one of the pioneers with this marketing approach, and has successfully used the program to not only expand its client base, but also gain loyalty from its cardholders. Even though other card issuers have begun to offer some of these perks, Discover continues to manage one of the most competitive cashback programs in the industry.

At the end of 2012, the company had more than $49 billion in receivables. In addition to the transaction fees the card issuer charges merchants, Discover also collects interest on the balance of receivables.

In order to effectively grow, Discover has used a dual focus on cardholders and merchants. After all, it doesn't help to have a wide base of cardholders if few merchants accept your cards as payment.

Over the past five years, Discover has grown its merchant base by an average of 6% per year, giving cardholders much more flexibility when making purchases.

It is important to note that "active merchants" includes all merchants that are currently conducting transactions. So there are no legacy merchants included in the figure that are no longer actively clearing customer payments.

Over the next few years, Discover will use this installed base of customers to build additional lines of revenue and boost profitability.

New Products Expand Revenue

In addition to being a credit card issuer and payment processor, Discover Financial Services also offers traditional banking services.

The company is able to accept deposits, holds $11 billion in personal loans, and also offers cashback checking.

This year, the company is focusing specifically on growing its home equity business along with its direct checking business. Both of these areas should allow Discover to capitalize on its wide base of existing customers, cross-selling products based on the needs of individual clients.

I'm excited to see how quickly the new lines of business can begin generating a significant amount of revenue for the company. Discover should be able to grow these new business lines much more efficiently than competitors because prospective clients are already in the system and loyal to Discover.

As the new revenue streams pick up, Discover Financial Services will see a boost in income that should drive share prices materially higher.

Keeping a Handle on Risk

The primary risk metric that investors need to be aware of in this business is the credit risk of the receivables relating to the company's card balances.

While the majority of lenders still face some residual risk from the global financial challenges, Discover appears to have its risk at a very manageable level.

The company has been able to keep a charge-off rate below the industry average. Also, Discover has been working on increasing the credit quality of cardholders who hold a balance with the company. At the end of 2013, 83% of the company's receivables held a FICO score above 660.

Finally, the company has a healthy balance sheet with enough cash for the board to authorize a two-year $2.4 billion share repurchase agreement.

Discover appears to have the perfect mix of growth opportunities, coupled with well-managed risk. This balance creates an attractive profile for investors.

Better Than the Competition

Although Discover Financial competes directly with the two primary card issuers, the company has a significant advantage. Visa Inc. (NYSE: V) and MasterCard Inc. (NYSE: MA) are not in the business of extending credit to individual cardholders.

Instead, Visa and MasterCard work with issuing banks that provide the actual capital to cardholders. Visa and MasterCard simply collect fees for clearing the payments (without taking on any credit risk).

This approach reduces the risk for Visa and MasterCard. These companies just need consumers to continue to clear payments in order for them to collect revenue. But the downside of this reduced risk is that Visa and MasterCard do not collect ongoing interest payments for balances the cardholders carry.

In today's environment, Discover Financial has the upper hand. Credit concerns are not nearly as problematic as they were several years ago, and Discover certainly has more ways to generate revenue than the traditional card issuers.

A Tremendous Value

Finally, Discover Financial trades at a valuation discount to Visa and MasterCard. Discover currently trades at roughly 10 times next year's expected earnings. This is a very reasonable price, given the company's growth prospects and the fact that Discover has a 1.8% dividend yield.

By comparison, Visa is valued at more than 20 times next year's expected earnings and MasterCard is valued at about 19 times forward estimates. Both Visa and MasterCard have much lower dividend yields (less than 0.5%).

This valuation discrepancy is likely because investors are still hesitant to take on credit risk. Since Discover Financial could be vulnerable to defaults in the future, investors aren't willing to pay as much for the earnings that Discover produces.

Of course this is a risk that should be considered, but it looks like investors are placing far too much weight on the risk of default, without accounting for the significant revenue Discover receives from credit balances. Also, the fact that the company is increasing the overall credit score of its portfolio helps to mitigate risk.

Discover Financial represents a tremendous value for investors. Even though the stock has rallied significantly over the past 18 months, there is still a significant amount of profit to be made with this stock.

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