Is The Market Undervaluing These 2 Stocks?

Is The Market Undervaluing These 2 Stocks?

Certain credit card issuers don't seem to be getting much respect on Wall Street. Discover Financial Services and Capital One Financial look to be selling at a noticeable discount to more esteemed financial-services competitors such as American Express . Do these card companies really deserve such irreverence, or are they bargain stocks worthy of consideration?

Two companies not getting much credit
Discover Financial Services looks to be a company that generates little enthusiasm, though the company is one of the largest credit-card issuers in the United States. Best known for its Discover Card, it also offers home loans, private student loans, and other banking services.

The card provider has performed reasonably well, recently reporting quarterly income of $593 million, though it was a drop of around 7% compared with 2012. The decline was mainly due to a $42 million credit loss expense this year, versus a $167 million reversing gain last year. Credit loss expense, the chief risk to credit card issuers, can be very volatile period to period. But bad loans don't seem to be an issue at the moment. The rate for credit card loans over 30 days past due was 1.67% of amounts outstanding, an improvement from 1.83% in 2012.

Discover shares currently look cautiously priced. Maybe too much so, given loan growth of 5% in the most recent quarter and an expected 3.1% return on tangible assets -- respectable metrics in the financial-services industry. Trading around 10.5 times adjusted cash earnings, or net income plus non-cash charges reduced for capital outlays, the shares appear worth a look.

Card issuer Capital One Financial is another company getting little respect. With $290 billion in total assets, the company was the fourth largest issuer of Visa and MasterCard credit cards in the U.S. at the end of 2012. Capital One also offers commercial lending, auto loans, and mortgage banking services, both directly and through more than 900 branch locations.

The company announced income of $1.1 billion in its latest quarter, when adjusting for a $101 million litigation expense this year -- basically flat compared with 2012. Profitability was aided by a 16% decrease in credit losses, offsetting a revenue drop of 2%. Credit quality remained reasonable, with an over-30-day delinquency rate on all loans at 2.54% of balances outstanding, equal with 2012 figures.

What's interesting about Capital One is that it looks to be diversifying away from the cards business, which accounts for about 40% of loans but 60% of revenues and profits. A February sale of its $7 billion Best Buy credit card portfolio to Citigroup was one step. A move toward more traditional bank-like commercial and auto lending, helped by a $9 billion acquisition of ING Direct USA in 2012, is another.

The company also hopes to become a major commercial property lender, as seen from its acquisition of Beech Street Capital last August.

The market doesn't seem very impressed with the company's moves, however. Capital One looks to trade at a severely depressed 8.5 times cash earnings. A reason might be its 1.8% expected return on tangible assets. Lower than card-issuing peers, the return is still slightly higher than the average for traditional banking companies. Given that traditional lenders, such as Wells Fargo, have market values generally around 11 times, Capital One might be excessively discounted.

One competitor getting much more respect
The stock market seems far more enthused about the well-known card issuer American Express. The company's famous charge-card product and travel-related service brand certainly helps. The company notes that its name has consistently been rated one of the most valuable brands in the world, and that it provides a significant competitive advantage. Results seem to support the assertion.

In the latest quarter, American Express reported income of $1.4 billion, up 9% from a year ago, the increase helped by a rise in cardholder activity. This is important, as discount revenues, which are merchant fees generated by cardholder use, are the company's biggest revenue source. It makes up around 53% of total sales.

The company also noted that credit quality remained at historically strong levels. Card member receivables -- representing amounts due from customers who must pay the full amount billed each month -- more than 30 days past due were around 1.7% of the total, as compared with 1.8% last year.

Card member loans, basically similar to "regular" credit card products where customers are typically required to make only minimum monthly payments, had a similar drop in late loans, with only 1.1% past due over 30 days versus 1.3% in 2012.

American Express looks fully priced in the market at roughly 17.4 times cash earnings. The company's strong 3.4% return on tangible assets, exceptional brand awareness, and generally stable revenue stream seem to provide investors with little concern.

Is Mr. Market wrong?
The market appears to be discounting certain credit card issuers, as this summary describes:



Capital One

American Express

Total assets

$75.5 billion

$289.9 billion

$150.0 billion

Cash earnings

$2.36 billion

$4.82 billion

$5.05 billion

Return on tangible assets




Market multiple




Source: various SEC filings.

While Discover Financial and Capital One might deserve a lower multiple to American Express because of AmEx's more stable fee base and strong brand, the discounts may be excessive given the sound financial results they have produced. Based on the low market multiples, these eschewed card providers might be offering a bargain opportunity for the intrepid investor.

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The article Is The Market Undervaluing These 2 Stocks? originally appeared on

Bob Chandler owns shares of Discover Financial Services. The Motley Fool recommends American Express, MasterCard, Visa, and Wells Fargo and owns shares of Citigroup, MasterCard, Visa, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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