Discover Financial: An Average Banana at a Great Price?
[Here is my write-up for Discover Financial Services. To see all the charts, figures, and valuation scenarios, visit the Seeking Alpha version of this article.]
One mistake many investors make is assuming that buying stock is solely about picking out the best companies. The quality of a company is certainly an important consideration when investing, but price is just as important. As an investor, you like quality, but you also want to seek out stocks that give you the most favorable risk-reward prospects.
In my article several months ago about taking advantage of bankruptcy risks, I compared investing to buying fruit. Let’s say you want to buy bananas at the grocery store. You examine the external aspects of the bananas trying to make projections about what’s on the inside. You see a banana that appears to be “prime quality” and you believe there is a 90% chance it meets your standards for consumption. You then see another banana that looks alright, but you have more doubts about it. You assess the odds of this “average quality banana” meeting your standards for consumption to be about 70%.
Now imagine you walk into the grocery and you see a big table with all these bananas setting on it with a sign that says “bananas --- 80 cents.” Undoubtedly, you seek out the “prime quality” bananas. Most investors instinctively grasp this. Prices being equal, you always go for higher quality.
On the other hand, what if the grocer realizes it can sell the “prime quality” bananas at a premium and is having difficulty selling the “average quality” bananas at the 80 cent price. Maybe the grocer begins to segregate the bananas by quality and offers the “prime quality” bananas for $1.20 and the “average quality” bananas for 50 cents.
Which pile do you buy from if you’re only buying one? How about if you have enough money to buy $5 worth? Would you be better off buying four “prime quality” bananas at $4.80 or nine “average quality” bananas at $4.50? If you buy the four “prime quality” bananas, the odds suggest that at least three will be eatable and there’s a good chance that all four meet your standards. On the other hand, if you buy the nine average quality bananas, the odds suggest that you would obtain either 6 or 7 eatable bananas. Hence, from a risk-reward perspective, you got a better deal by taking advantage of the price discrepancies and nabbing up the “average quality” bananas.
The quality and pricing of bananas may not seem to have all that much to do with the stocks of credit card companies, but I’d argue it does. My concern right now is that Visa (V) is that high quality banana selling at a significant premium while Discover (DFS) is the average quality banana selling at a discount. But let’s quit talking about bananas and take a look at Discover Financial Services.
Discover’s Business Model
One interesting thing about the various competitors in the credit card sphere is the distinctness of the business models. Visa, for instance, does not take on the credit risks of those utilizing their cards. Instead, they make their revenues from service fees, data processing fees, and transaction fees. American Express (AXP) makes the largest chunk of their revenues from “discount fees”, which are similar to Visa’s “service fees”, but AXP also collects interest income, as well.
Discover is unique in the sense that it is involved with all stages of the food cycle, so to speak, since they are a credit card issuing company, an electronic payment services provider that owns its own U.S. payment network, has both credit and debit functionality, and acts as an originator of loans and other banking products. In other words – they do everything. Of course, that’s one of the major reasons why the market has soured on Discover, but has been less harsh on Master Card (MA) and seems mildly optimistic about Visa. Discover is lumped in with the banks that have taken on too much credit risk and have been hit hard as their stock price has fallen from peaks in the upper $20 range all the way down to $4 – 5 range, before jumping back up to the $6 – 7 range, where it sits now.
Contrary to popular market sentiment right now, this might not be such a horrible thing. Many people compare credit card debt to subprime loans, but there is one important distinction: the credit card companies charge rates that are more in line with the risks involved than subprime lenders did. Moreover, they have the flexibility to change those rates as conditions change. This is not to suggest that all is good and well in Credit Card Lending Land, but it is to suggest that the fears about them might be overblown.
It Will Be Brutal
All the same, 2009 is likely to be a brutal year for Discover. Discover reported earnings of 25 cents per share for the 1st Quarter, but that’s a bit deceiving since they claimed $475 million from the Visa antitrust litigation settlement. Ignoring that special item, Discover’s income for the quarter plummets to 73 cent per share loss. That’s pretty ugly. If that trend were to hold up, they could lose $3 per share in normalized income for this fiscal year.
But wait there’s more! CEO David Nelms states that the charge-off rate for the 1st Quarter came in at 6.5% and they expect the loss rate for the second quarter to exceed 7.5%. If unemployment continues to rise, that rate could get even higher.
However, the question isn’t so much whether this year will be bad for them. We already know this year will be dreadfully awful. The question is how bad will it be and how much has the market already discounted the stock price for this terrible news?
If there is any consolation, it’s that their cash flows are still positive. For the 1st Quarter, Discover brought in $528 million in operating cash flows. It’s not completely clear to me whether they received the entire antitrust litigation settlement claimed in their Income Statement, but assuming they did, they still brought in $53 million (11 cents per share) discounting that item. Hardly a reason for great optimism, but it emphasizes the fact that most of their earnings loss comes from a higher charge-off rate for their “Provision for Loan Losses.” That brings me the one big positive here --- Discover’s balance sheet.
A Strong Balance Sheet
It’s not that Discover is poised for a tremendous year and it’s completely possible they suffer for a few years. The good news is that they have a balance sheet that would appear to be strong enough to absorb these impending losses.
[See Seeking Alpha version of article for "Balance Sheet" chart]
There are a few important items to note. First off, Discover has nearly $8.7 billion in cash and interest-earning deposits (“cash equivalents”) on their balance sheet. That balance is equal to roughly a quarter of their total liabilities. Add an additional $1.3 billion in investment securities and that gives Discover about $10 billion in liquid assets compared to $34.6 billion in total liabilities.
Stockholders’ Equity is about $6 billion or $12.42 in per share terms. Goodwill and intangible assets are also fairly low, which means that figure isn’t distorted much. Once you discount goodwill and intangibles, net tangible assets (NTA) are equal to $11.47 per share. If the stock were selling at $7, that would be 64% discount to NTA.
Naturally, we need to assume that Discover will take some significant losses on their portfolio. The good news is that Discover would appear to be playing things fairly conservatively as it is. They claim a $1.9 billion “Allowance for Loan Losses”, which is about 6.7% of their total loan portfolio. I want to see how their equity (discounted to net tangible assets) will be affected by that.
[See Seeking Alpha version of article for "Impairment Table" chart]
The amazing thing about this chart is that it suggests that Discover could absorb a 25% impairment charge and still have slightly positive net tangible assets. Of course, that is a somewhat meaningless measure because they’ll be out of business regardless if they have that high of a write-off rate, but it at least shows you the strength of their balance sheet. While they most certainly have a lot of risky debt on their books, they charge interest rates that are reasonable given the risks, and they have the liquidity and equity to absorb potentially huge losses. This differentiates Discover from many of the banks that are struggling right now.
Looking at this chart, I would wager to guess that if Discover is selling at $7, they could absorb a 10% - 12% delinquency rate and still be alright. That brings me to my primary rationale for believing that Discover might be a decent buy right now – the price already factors in astronomical losses. While the stock price has been particularly volatile, in the $6 to $7 range, it would appear that the market is expecting an extremely high amount of write-offs.
Now that we’ve seen why this stock might be a worthwhile buy, let’s take a look at potential valuation. Undoubtedly, valuing Discover’s stock can be tricky. This is due to the high amount of uncertainty and risk inherent in their business and the current economic environment. Therefore, I am going to try to deduce a “probable valuation”, which is by no stretch of the imagination, an encouragement to buy at anything below that price. Rather, it’s the price I believe will most closely reflect Discover’s true value.
At the same time, you need to factor in the high levels of risk and uncertainty. For a company like Red Hat, which I analyzed back in mid-January, we can assume a much greater level of certainty about their near-term earnings and cash flows and hence, “probable valuation” might be fairly close to a price-point where I might consider it a “buy.” The same cannot be said for Discover. The high level of risk and uncertainty means I need to further discount the stock. Therefore, I will also look at potential downside valuations and upside valuations.
Normally for valuation purposes, I focus on free cash flows (FCFs). Occasionally, I look to operating cash flows and earnings for guidance, but the primary focus is on FCFs. For Discover, I’m going to focus on earnings instead. My primary reason for this is that earnings will probably be more conservative and they appear to be more predictable. Here are the scenarios:
[To see valuation scenarios, see Seeking Alpha version of this article]
I never take the numbers a spreadsheet pumps out at face value. The important thing to understand is why one gets different results and how varying dynamics will change valuation. Based on these four scenarios, I come up with a probable valuation at $17. However, due to risk and uncertainty, I do not believe risk-reward favors the long-side unless the stock price is below $9 - $10. Under $8 it looks fairly attractive. In the $5 - $7 range, I would personally consider buying into it.
Upside potential for Discover in the next eight years might be in the $30 range. Downside risk is $0, but that won’t happen unless they go bust and given their strong balance sheet, it would take quite a lot to drag it that low. Assuming they survive, I’ll go with a downside risk of $3.
Earlier this week, I wrote about why I am bearish on Visa. I also stated that I believe Discover is a better alternative. In regards to Visa, it appears to me the market has priced in very high expectations for the stock and I am unsure that Visa can meet them.
Moreover, I believe the market is ignoring some of the risks associated with Visa. While Visa does not take on the debt risks of Visa cardholders, the banks that do will undoubtedly be lessening the amount of credit available in a prolonged recessionary environment. This means that Visa will collect fewer fees on transactions than expected.Moreover, given that Visa appears to be priced for near-perfection, I am not sure how much upside Visa can have. One commentator on my article suggested $120 might be the upside. Even that seems very aggressive and it’s worthwhile to note that this stock never climbed above $90 even when the bulls were out in full force. From my perspective, Visa has a sizable downside and a limited upside.
On the other hand, while Discover has a noteworthy downside, it also has a huge upside. In the $6 - $7 range, I believe the odds favor at least a 100% return. At the $8 - $9 range, there’s still a good chance for double on the initial investment. I do not think $20+ is as far-fetched as some might believe, either. For this reason, Visa might be the proverbial overpriced “prime quality” banana, while Discover might be the underpriced “average quality” banana. I’d prefer to buy the latter.
Of course, there are reasons to believe that Discover might be a little bit better than average. My esteemed colleague Ryan Pollack pointed out in his bullish case for Visa that Visa has a tremendous advantage in market share. That might seem good to some investors, but to me, it’s also a bit dangerous. If one company has a majority of the market share, how much more can they expand in relation to their competitors? Discover has more room to grow than Visa.
Seeking Alpha contributor Frank Rong made an excellent case last July as to why Discover (and American Express) are better investments than Visa and Master Card. In that article, he mentions Discover’s increasing acceptance parity with Visa and Master Card. This is an excellent point because that has been one of the hardships Discover has faced in the past. As a Discover cardholder, I know this firsthand. Back in 1999, maybe 20-25% of the places I shopped would not accept Discover. Now, that number has declined significantly; it’s probably more like 5-10% now.
Discover also has a great amount of brand loyalty. You might even say that’s the only thing that has allowed them to survive through some of their formative years. Discover is, after all, “the card that pays you back.” I’m a bit disappointed they abandoned those commercials, but the fact remains that it was a clever idea and it’s still a good benefit, even if the other cards have been trying to mimic it with their own rewards programs. It’s also worth mentioning that the Diner’s Club acquisition was one of the shrewder moves made over the past few years. Discover should bring in substantial revenue from this acquisition.
I’m not suggesting that I believe Discover is going to experience 20% growth and overtake Visa or Master Card any time soon. But I am suggesting that if you peel away the skin, there’s a decent chance that you’re in fact getting a “prime quality” banana with Discover. But even if it simply stays an “average quality” banana, it still looks attractive to me at the current price levels.
Overall, the main takeaway is that the market is underestimating Discover’s growth potential and is overreacting to the effects of the financial crisis on Discover’s loan portfolio. Whereas, the market is pricing in too high expectations into Visa, which does have competition overseas in the markets it would like to grow in. As a risk-reward proposition, Discover makes a lot more sense to me at the current prices.
Disclosure: Author holds no position in any of the companies mentioned in this article, but may choose to initiate a position in DFS in the future.