DISCOVER FINANCIAL SVCS INC DFS
July 15, 2014 - 2:29pm EST by
Shoe
2014 2015
Price: 62.79 EPS $5.47 $6.11
Shares Out. (in M): 472 P/E 11.5x 10.3x
Market Cap (in $M): 29,637 P/FCF 11.5x 10.3x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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  • Financial services
  • credit card
  • Payment services
  • Consumer Finance

Description

 

Discover Financial Services (ticker DFS) – long                

Upside: +35-50% from $62.79

 

Quick Pitch

-          DFS (the credit card issuer) trades around 10x 2015 EPS despite having industry leading ROEs and growth, in addition to a valuable payment network

 

Business Overview

-          Discover is the 3rd largest credit card brand by cards in use and the 4th largest by card balances

-          Highly profitable:

  • DFS has consistently been generating 20-30% ROEs (despite having excess equity) over the last 3 years (similar to American Express) and that is expected to continue
    • other banks and Capital One are generating ROEs around 10-15%
  • They focus on prime borrowers
  • They’ve generated positive ROE through the cycle (even positive in 2009)
  • From 2002-2007, they consistently generated high teens ROEs every year
  • Well run: their pre-tax margins are in the 40%s vs. other card issuers in the 20%-30%s
  • DFS has shown discipline throughout the credit cycle

-          Segments

  • Direct Banking
    • Includes consumer finance and direct banking products: such as their credit cards, student loans, mortgages, personal loans, and deposit products.
    • Loan Mix: ~87% credit card, 6% personal loans, 6% private student loans
    • Direct Banking represents ~90-95% of DFS’ net revenues and pre-tax earnings
      • 75% of the firm’s net revenues are derived from net interest income
      • 15-20% from discount rate
  • Payment Services
    • Includes the card network revenues outside Discover’s proprietary credit card business
      • e.g. transaction fees charged to 3rd party debit issuers using the PULSE network
    • ~4% of firm wide revenue, and ~5-10% of pre-tax earnings

 

Bull Case / Positives

-          Proprietary Network:

  • The company is unique in that is operates a closed loop payment network (like American Express), which allows it to capture more of the value in a transaction

-          Highly overcapitalized (by ~25-30% with a tier 1 common ratio of 14.8% - vs. mgmt’s target of 11%, and an average of 7.6% ratio for other large banks and the 5% minimum threshold)

  • DFS has been returning 80-90% of its earnings to shareholders (through buybacks and dividends)
    • It could return over 100% of earnings to shareholders in 2015 and beyond
    • Annually, DFS shrinks its share count by about 5-7% and has a 1-2% dividend yield
  • At some point, regulators should allow DFS to return more capital shareholders, or DFS will use it for an accretive purchase or asset deployment
  • If DFS used all that capital to buy back stock, they could theoretically raise EPS by 25-30%

-          Management: The CEO (David Nelms) is considered to be the one of the best in the industry and has been at DFS since 2004

  • He sticks to what he knows and does best: i.e. credit card lending and balance sheet management
    • Other credit card companies are all trying to do what is en vogue – which is to go after the ‘transactor’ business, leaving the profitable credit card loan business open
  • DFS has consistently outperformed the industry in terms of growth, margins, loss rates, and ROE
  • David Nelms owns $120mm of DFS stock (0.4% of outstanding)
  • 69% of his compensation is variable and tied to the company’s stock

-          Organic Growth:

  • High-single-digit % CAGR in EPS; mid-single-digit growth in top line
  • Mgmt has pushed into student lending and home mortgages when others were pulling out, which turned out to be a smart approach and drove modest growth and risk-adjusted returns
  • They’ve also been building out their checking platform
  • Since 2004, EPS has grown at a 12.9% CAGR
  • Since 2006, tangible book value has grown at a 10.3% CAGR
  • DFS has consistently been able to outgrow peers

-          Payment network: provides interesting upside optionality

  • DFS is unique in that it has a payment network that is currently underutilized
  • They are entering into various partnerships in order to drive volume on their network. E.g. with
    • PayPal – enabling offline payments at brick and mortar stores
    • Ariba – which handles $450bn of B2B transactions annually
  • Unfortunately, likely low probability of success and somewhat small at the moment

-          Catalysts:

  • Capital return: they’re 25-30% overcapitalized, which allows for significant capital return / stock buyback, which management is adamant about doing (they’ve indicated this desire during my meetings with them and publicly)
  • Payment network optionality: would be great if one of their partners really started contributing
  • Continued solid growth outpacing the industry
  • Rising rates should help NIMs as well

-          Valuation:

  • Currently trading at 11.5x 2014 EPS, 10.3x 2015 EPS, and 8.8x 2016 EPS
    • Cheap on an absolute and relative basis despite industry leading metrics and growth
  • Trades at 2.7x P/2014 Tangible Book
    • Appears elevated on a P/TB basis, but that is warranted given their high ROEs

-          Price Target:

  • In a year, DFS could trade at a more reasonable 14x 2015 EPS or $85.5,  for about 36% upside
    • 14x would be a premium to other large cap banks, but still within reason and a discount to AXP and V/MA
  • If they can return all of their excess capital through share buybacks, I could see $7+ EPS in 2016 (they’ll have to wait till the 2015 CCAR process at the earliest)
    • At 13x  $7.17 in EPS, the stock could trade at $93,  or 48.5% upside over a few years
  • SOTP:
    • Putting a 20x EPS multiple on the Discover Payment Network (closer to V/MA) and a 13.5x EPS multiple on the core banking franchise, yields $86.5,  +38% upside
  • Plus you get a 1.5% dividend yield

 

Bear Case / Negatives

-          Cyclicality: DFS is sensitive to the credit cycle and will experience decreased profitability when the cycle turns

  • Although in the short / medium term, card companies are in a great environment and credit losses are benign
  • DFS’ prime customer focus and historic credit conservatism have allowed it to perform well through the last cycle. 
  • Over the cycle, they’ve had lower losses & higher recoveries than peers
  • Its balance sheet is well diversified between customer deposits, bonds, and asset backed securities

-          Payment Services / Network

  • DFS has a great opportunity in its payment network, however management has had a difficult time driving volume on it, which has been disappointing
  • But this is a relatively small part of DFS’ earnings (~5-10% of total)

-          Competition:

  • The credit card industry is fairly competitive, which could cause NIM pressure
  • However, currently, credit card lending competition has been low since issuers are all chasing an AXP-like model and running off their credit card loan books, which is a positive for DFS
  • If competition depresses NIMs and/or net-charge-offs tick up, ROEs could go back to the high-teens as it was between 2002-2007, in which case DFS would generate $4.50 in EPS.
    • At an 11x EPS multiple, the stock would be down 21% to $50

 

History

-          DFS was originally part of Dean Witter Financial Services (which was a subsidiary of Sears).  In 1986 it launched nationally

-          Dean Witter spun off from Sears in 1993.  Then it merged with Morgan Stanley in 1997.  Discover is then spun off in 2006

-          Position history: we started investing in DFS in March 2013 when the stock was around $42 (currently at $63)

 

Financial Model

-          I model the Tier 1 Common ratio getting down to their target of 11% by year end 2016

  • I assume they use that capital for buybacks and slight dividend increases

-          Net income growth lags because they continue to invest in the business to drive organic growth, and there’s some increase in reserves & provisions as the loan book grows

-          Since DFS has been returning 80-90% of EPS back to shareholders, and is trying to return 100%+ eventually, EPS is a decent proxy for FCFE/share

 

 

 

2011

2012

2013

2014

2015

2016

Total Revenue ($mm)

7,087

7,690

8,224

8,683

9,143

9,620

Revenue Growth

 

8.5%

6.9%

5.6%

5.3%

5.2%

Pre-Provision Earnings

4,525

4,616

5,070

5,472

5,818

6,219

Pre-Provision Growth

 

2.0%

9.8%

7.9%

6.3%

6.9%

Pre-Provision Margins

63.8%

60.0%

61.6%

63.0%

63.6%

64.7%

 Net Income

         2,225

         2,325

         2,439

         2,529

         2,641

         2,825

 Net Income Growth

 

4.5%

4.9%

3.7%

4.4%

6.9%

 EPS

$4.12

$4.50

$5.01

$5.47

$6.11

$7.17

 EPS Growth

 

9.2%

11.3%

9.3%

11.7%

17.4%

 P/E

15.2x

14.0x

12.5x

11.5x

10.3x

8.8x

 Shares

            540

            517

            487

            462

            432

            394

 Share Decline

 

-4.3%

-5.8%

-5.1%

-6.5%

-8.9%

Tangible Book Value

$15.0

$17.7

$20.7

$23.1

$24.3

$24.2

P/TB

4.2x

3.5x

3.0x

2.7x

2.6x

2.6x

 

 

       

 

Stock Price

$62.79

 

 

 

 

 

 

  

Comp Table (couldn't paste it) 

  • Discover screens cheap on a relative and absolute basis vs. other banks and card issuers, despite have leading ROEs, capital ratios, and growth

 

 

 

 

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

-          Catalysts:

  • Capital return: they’re 25-30% overcapitalized, which allows for significant capital return / stock buyback, which management is adamant about doing (they’ve indicated this desire during my meetings with them and publicly)
  • Payment network optionality: would be great if one of their partners really started contributing
  • Continued solid growth outpacing the industry
  • Rising rates should help NIMs as well
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