Discover Opens New Doors

06/16/2010 1:30 pm EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Michael Kon say the credit card issuer is catching up with rivals even in the face of weak consumer spending.

Discover Financial Services (NYSE: DFS) operates one of the two closed-loop credit card networks in the United States; American Express (NYSE: AXP) operates the other.

Discover issues proprietary cards, extends card loans to cardholders, and acquires transactions from merchants whenever a cardholder pays with a Discover card. It has also developed relationships with third-party issuers such as Wal-Mart Stores (NYSE: WMT) to issue Discover cards to its customers. In addition to credit cards, Discover operates a PIN-based debit card network, Pulse.

Once inferior to peers’, Discover’s credit card network is catching up as merchant acceptance levels approach those of Visa (NYSE: V) and MasterCard (NYSE: MA).

The acquisition of Diners Club provides Discover with an international footprint and adds millions of foreign merchants to the pool of merchants that accept the card. These actions expand the firm’s moat because they are likely to increase card usage, making it less appealing for cardholders to use other cards.

Nevertheless, we expect lending to remain Discover’s main business line.

Unlike Amex, which earns a boatload of fees (over 80% of revenue), the bulk of Discover’s revenue (about 60%) comes from the spread on card receivables. This suggests that Discover doesn’t fully monetize the operating leverage embedded in its network and has to rely on the performance of its receivables to fill its coffers.

While Amex can enjoy a stable stream of fee income, Discover has to handle credit risk, interest-rate risk, and competition from giants like Capital One (NYSE: COF). All this said, Discover has a solid brand name and a network that, despite all the disadvantages, would be hard to duplicate.

The firm also boasts lower attrition rates than other card issuers, because cardholders tend to keep using their Discover cards once they get used to paying with them at certain merchant locations. In addition, Pulse makes Discover a force to be reckoned with in the debit card market, which is growing much faster than the mature credit card market.

However, the industry is facing a decline in spending and deleveraging of the US consumer, which bodes ill for balance sheet and revenue growth. In addition, rising unemployment in the US is driving loan losses, a trend that’s likely to persist for a while longer.

We think charge-offs are likely to keep rising in 2010, but we expect Discover to fare better than peers in the current cycle. We model net charge-offs of 8% in 2010, 7% in 2011, and 5.5% in the long run.

A 50-basis-point increase in our long-term net charge-off assumption would result in a $4 decline in our fair value estimate, [which] remains $27. The opening of the network to third-party issuers and acquirers will help Discover increase card volume in the long run, but consumer spending is a major head wind for near-term growth. We forecast loans to remain flat in 2010, but to increase by 3% in 2011 and by 5% thereafter.

(The stock closed below $14 Tuesday—Editor.)

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