Why Discover Financial Is No Longer Undiscovered
With the release of Q3 earnings scheduled for Thursday, Sept. 27, it may seem premature to discuss the opportunity Discover Financial (NYS: DFS) offers investors. As Fools well know, jumping in ahead of earnings can be a risky proposition -- poor results, or good results but missing analyst estimates, can translate to short-term selling pressure.
But here's the thing: What makes Discover worth your time isn't merely the settling of the recent FDIC mess, analysts suddenly becoming enamored with the once-downtrodden financial provider, or even its undervalued stock price relative to the sector. It's the combination of all of those things, and a few more interesting tidbits, that should have long-term investors taking aim at Discover.
Not so long ago
The day before Discover announced fiscal 2012 Q2 results on June 19, the stock was trading at a ho-hum $32.83 a share. The depressed share price seemed justified after Discover announced earnings of $1.00 a share, compared to $1.09 for 2011's second quarter. A closer look, which is what we did in an article at that time, revealed that the 9% increase in loan volume resulted in the need for a higher loan provision -- after some rather complicated calculations.
Some of Discover's loan growth was due to the $2.4 billion in student loans it acquired in Q4 of last year. So, analysts and many investors seemed to write off the loan volume increase -- too bad. Because even without the student loan portfolio, a $2.1 billion jump in total lending wasn't anything to sneeze at. The upside? The "poor" showing in Q2 has somewhat muted the slow, but steady, growth in Discover's share price, leaving time for investors who didn't act in June.
Fast forward to today
First, the bad news: Discover and the FDIC settled the customer marketing dispute, accusing it of pressuring customers into buying additional services like credit monitoring; and even enrolling some customers without their knowledge. Discover's agreed to pay a total of $214 million, $200 million of which will be returned to customers affected by the unlawful practices, and $14 million to the FDIC.
Well, that's not good, and hopefully Discover's learned its lesson. But right or wrong, it's hard to imagine the ruling impacting Discover, other than a short-term blip. There are simply too many positives for growth-oriented investors to ignore Discover -- fine, or no fine.
There are those who will continue to question Discover's $2.4 billion loan portfolio acquisition decision. It still seems like an odd choice, particularly given the political climate surrounding student debt. The saving grace however, is that the student loan portfolio is a relative drop in the bucket of Discover's $57.1 billion in loans, as of Q2 2012.
The recent confirmation of Discover's $0.10 a share dividend shouldn't be discounted. A 1.04% yield isn't earth-shattering, but it compares favorably with others in the industry. American Express (NYS: AXP) , Visa (NYS: V) , MasterCard (NYS: MA) , and Capital One (NYS: COF) aren't exactly income machines either. Of the four, American Express and its 1.39% is the only dividend yield higher than Discover.
From a fundamental perspective, Discover does more than hold its own. Unlike Visa, MasterCard, and Capital One, which issue credit cards via third-parties, Discover and American Express go straight to the consumer. It's this business model that makes Discover's operating margins and net profit margins so impressive. The third-party card issuers aren't saddled with as much overhead as Discover and American Express. Yet, Discover's margins are comparable to Visa and its brethren, and blow American Express out of the water -- more than double the margins in both areas.
On an earnings basis, Discover's 8.95 P/E is the lowest in the industry: Only Capital One's 9.67 is in the same area code.
Perhaps not surprisingly, Discover analysts are starting to come out of the woodwork with strong buy recommendations. Expected earnings for Q3 have increased from $1.02 to $1.04 a share, and over 76% of analysts rate Discover a good investment. About time.
On the legislative front, the implementation of the first phase of Basel III in 2013, and the tightening of bank lending standards it's expected to bring, will be good for all credit card companies. Susquehanna Financial suggests Discover could see earnings jump 44% as a result of Basel III, as $800 billion in home equity loans will no longer be available through traditional banks.
Discover Financial isn't quite the hidden gem it was starting the summer, but it remains one of the best values in what most agree is going to be a great industry into 2013, and beyond.
Basel II or no Basel III, there are opportunities to be had in the more traditional, large banking sector. Of all the choices out there, Wells Fargo may top the list. To learn more about this industry leader, and the risks investing in Wells represents, take a look at the Fool's special free report.
The article Why Discover Financial Is No Longer Undiscovered originally appeared on Fool.com.
Fool contributor Tim Brugger currently holds no securities positions mentioned in this article Motley Fool newsletter services have recommended buying shares of Visa. Motley Fool newsletter services have recommended creating a write covered strangle position in American Express. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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