Consumer debt rocks credit card stocks

By Dale Jackson
Globeinvestor Magazine Online, July 8, 2008

The honeymoon appears to be over for newly listed Visa Inc. The stock more than doubled in less than two months after its $29-billion (U.S.) initial public offering initial public offering in March – only to be cut down 13 per cent in the past two months.

Worse yet, the marriage between credit-card stocks and investors is being rocked by rising consumer debt and the worsening economy.

International ratings agency Fitch Ratings predicts losses from defaults on outstanding balance payments for all credit-card issuers will rise to at least 7 per cent by the end of the year. In May, credit-card companies were expecting defaults to reach 6.4 per cent.

MasterCard Inc., which went public in May, 2006, is also feeling the pinch. The stock is still up 57.5 per cent from this time last year but has lost over 20 per cent of its value in the past month.

Despite the gloomy outlook, analysts remain relatively positive on both stocks with an even split between buy and hold ratings. Last quarter MasterCard reported profit more than doubled and Visa posted a 28-per-cent earnings increase from the previous year.

UBS Investment Research analyst Adam Frisch has buy ratings on both, citing a growing global appetite for credit. “The global secular growth story of paper to plastic should go unabated for the foreseeable future, both in the U.S. and much higher growth regions around the globe,” he says in a recent report on Visa.

The report also mentions a “consumer spending slowdown” as a risk but includes slower growth in cross-border transactions and pricing pressure from large banks.

Citi Investment Research analyst Patrick Burton has a less enthusiastic “hold/high risk” rating on Visa and MasterCard. In his most recent report he says slow U.S. economic growth could hit MasterCard’s bottom line but Visa – the world’s largest credit card issuer – appears to have more exposure.

“Visa is highly leveraged to consumer spending and global travel trends, and weaker than expected economic growth could have a greater-than-expected adverse impact on purchase volumes and transactions processed – and ultimately the company’s earnings,” he says.

Stephen Wood, a senior portfolio strategist at New York-based Russell Investment Group, has been steering his clients away from any financial stocks – including credit-card stocks. “The concern is that consumer debt is of deteriorating quality,” he says of credit-card losses among the more diversified financial services companies such as banks.

Default risk aside, the slumping economy and rising consumer debt levels are not motivating credit-card holders to look for better borrowing terms, says Dave Trahair, a Toronto-based chartered accountant and consumer debt specialist.

While the benchmark U.S. lending rate made its way down to the current level of 2 per cent, Visa, MasterCard and American Express have been generating those huge profits on the backs of customers who often pay 18 to 20 per cent on balances.

“It’s a hassle to apply for a different credit card and transfer everything over so most people continue to do what they do, which is an advantage to the credit card companies,” Mr. Trahair says.

High rates and a sluggish economy didn’t stop U.S. consumers from borrowing $34-billion (U.S.) in the first three months of this year – the biggest increase in seven years. According to data compiled by Oppenheimer, card users paid only 19.8 per cent of their balances in May compared with 20.7 per cent a year earlier. A recent survey by Statistics Canada shows 40 per cent of Canadian credit card holders regularly pay interest on their monthly balances.

Capital One recently introduced a card that caps interest payments at 0.9 per cent above prime but most traditional card holders continue to reject the long-standing option of paying their balances with a much lower consumer loan or secured line of credit.

Mr. Trahair says there could be a tipping point where consumers wise-up to high credit card rates – but that’s a long way off. “Human nature is not all of the sudden going to change.”

Other major publicly traded pure-play credit card companies include American Express (AXP/NY), Discover Financial Services (DFS/NY) and Capital One Financial Corp. (COF/NYSE). They differ from Visa and MasterCard because they lend directly to customers and, as a result, take on greater risk. Visa and MasterCard issue cards through financial institutions, which assume much of the credit risk. Most major banks own a stake in credit card companies.

Of the 18 analysts who cover American Express, seven have a buy rating, eight have a hold rating and three are advising clients to sell.

Capital One lost $4.16-billion (U.S.) in defaults last year and its stock took an 18 per cent hit on its value last month. Five analysts have buy ratings, seven have hold ratings and six recommend selling.

Discover Financial Services – which has lost half its market value since being spun off by Morgan Stanley in June 2007 – has only two buy ratings, seven holds and three sells.

Earlier this week Deutsche Bank raised its recommendation for all three stocks to neutral from sell, stating the falling stocks now reflect the “weak” economic outlook.

Dale Jackson is a producer at Business News Network.