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A Discover Financial Services credit card (Scott Eells/Bloomberg)
A Discover Financial Services credit card (Scott Eells/Bloomberg)

Financial Services

Also-ran of credit cards is a winner for investors Add to ...

One of the many philosophies former GE boss Jack Welch introduced into the business culture was the importance of being number one or number two in your industry; failure in that, it was suggested, merited a hard look as to your long-term prospects for success.

So is there really any money to be made investing in Discover Financial Services, owner of Discover Card, the number four credit card brand in the United States? The answer, perhaps surprisingly, is yes, as the company combines solid profit growth with an eminently reasonable valuation, despite recent gains in the shares.

First, some background. Canadians are well aware of the names ahead of Discover. By U.S. purchase volume, Visa ranks first with 43 per cent, and MasterCard and American Express have roughly 25 per cent apiece. Discover trails badly, at 5.7 per cent. (The figures are from 2010 and were compiled by Susquehanna Financial Group LLLP analyst James Friedman.)

Discover is its own unique animal, however. Visa and MasterCard are card networks that enable banks such as JPMorgan Chase, Bank of America and the big Canadian players to issue cards. Discover and American Express, however, issue their own cards and operate “closed-loop” networks that link directly to merchants and allow them to keep more of the per-charge transaction fees.

But while American Express still mostly requires cardholders to pay off balances each month (making most of its money from fees), Discover makes money from interest charged to its cardholders. At the same time, it keeps merchant fees low in order to build the network of locations that accept the Discover Card.

And Discover is more bank-like than American Express, gathering deposits online from retail customers and making money off the generous spread between the deposits and the credit card balances. (It has also been expanding into personal and student loans, although the credit card portfolio remains dominant.)

This business model leads to some surprises, per Mr. Friedman’s report: There were actually more Discover Cards in circulation in the U.S. in 2010 (56 million) than there were American Express cards (49 million). And the number of locations that accept Discover (7.9 million) easily exceeds Amex (5.1 million).

If you’re following along, you may realize the combination of large penetration but lagging charge volume means Discover Card holders simply use it less – in many cases, it’s a second or third card out of wallet for its holders.

The buy case for Discover Financial Services, however, doesn’t rest on the company ever overtaking its larger competitors. Instead, the appeal is its slow but steady growth, coupled with surprisingly good credit quality.

Discover Financial Services managed to make it out of the recession with greater asset quality and fewer charge-offs than most of the big-bank card issuers.

That’s left the company with a strong balance sheet and a record year of profit in 2011, with the company earning well over $4 (U.S.) a share as it was able to set aside less money for potential losses than other financial companies.

This “reserve release,” as it’s called in the banking industry, was a one-time event that analysts don’t expect to repeat in 2012. So most are forecasting earnings per share (EPS) in the low $3 range.

That still yields a reasonable forward P/E of about 8, despite a bump-up in the shares from $24 to $28 so far this year.

Bullish analysts on Discover Financial Services, such as Mr. Friedman, who has a $32 price target, and Jason Arnold of RBC Dominion Securities Inc. ($35 target price) think investors fail to appreciate the company’s earnings-growth potential.

(Indeed, Globe Investor’s Number Cruncher column, assisted by CPMS, a unit of Morningstar Canada, last week put Discover Financial Services on a list of U.S. stocks that stand out for a demonstrated ability to grow, for rising earnings expectations and a reasonable valuation.)

Says Mr. Arnold: “We continue to view Discover Financial Services as the name to own in the card space, and we believe that the company is very well poised to take market share, as well as realize very strong returns and healthy EPS growth – tough to find in the financials sector at present.”

The healthy balance sheet also means Discover Financial Services has the ability to improve its dividend (current yield: 1.4 per cent) and buy back more shares, improving EPS.

All of which means that a perceived also-ran in the U.S. credit card market could become a leader in your portfolio.

Special to The Globe and Mail

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