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 3^rd largest credit card brand by cards in use and the 4^th 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 3^rd 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

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

Catalyst