Discover May Be Worth Betting On

IN A FIELD of flashy performers like the blue-chip American Express and the giant card networks MasterCard and Visa, Discover Financial Services has long been an also-ran. The Discover card's dorky, Middle American image — it was launched in 1986 by Sears Roebuck — is by now so firmly ingrained that it has been lampooned on the hit cartoon show Family Guy.

And in truth, Discover (DFS)has been something of a tortoise in an industry of hares, companies racing to exploit the tectonic shift of U.S. consumers using plastic rather than currency or checks for most of their purchases.

Discover not only started late but has also posted halting growth in credit-card receivables in recent years compared with its peers. The Discover card has a materially lower acceptance rate by merchants than the MasterCard (MA) and Visa (V), both in the U.S. and particularly abroad. This, of course, gives it a much lower "share of wallet" rate among the globe-trotting big-spender crowd, who typically yield fatter profits to credit-card companies in merchant fees and interest earned on credit balances.

In the first quarter of 2008, Discover's $47.5 billion in credit card balances were just 7% of the $666 billion in outstandings of America's six largest issuers. By comparison, Bank of America (BAC), JPMorgan Chase (JPM) and Citigroup (C) all had market shares of over 20%, and Capital One (COF) and American Express (AXP) each boasted shares of 10%.

Yet Discover may well be a tortoise worth betting on these days, just 14 months after it was unceremoniously dumped by Morgan Stanley in a spin-out. For one thing, Discover, as a result of its conservative credit policies, is likely to weather the surge in delinquencies and loan charge-offs that bad times are now unleashing on the U.S. credit-card industry.

At the same time, the company has negotiated a flurry of deals in the U.S. and overseas that figure to boost its cards' market penetration to levels close to the reach of Visa and MasterCard. Discover would benefit mightily from any growth in business volume because, unlike most other card issuers, it runs a "closed loop" network in which it not only issues credit cards but also does most of its owns transaction processing. That means that additional volume helps not only on the credit side but also in processing efficiencies.

On top of all that, Discover could be an attractive takeover candidate, regardless of whether the company succeeds in improving its competitive position. Buckingham Research Group stated in a July report that while Discover on a stand-alone basis has a sum-of-the-parts value of about $18.50 — it's currently trading at around $16 — it would command a premium of 20% to 30% more to an acquirer looking for scale in both credit-card issuance and processing.

William Ryan of financial-research boutique Portales Partners thinks that any takeover of Discovery would garner a price in the high 20s to the low 30s. A bonus to any acquirer is Discover's fast-growing Pulse debit card network, which handles electronic transfers on behalf of some 4,500 banks, credit unions and savings institutions across the U.S. and boasts links to about 265,000 ATMs and point-of-sale equipment.

To be sure, Discover figures to encounter some rough seas over the next year or so. Consensus analyst forecasts see Discover earning $1.52 a share for the fiscal year ending Nov. 30 of this year and $1.42 in fiscal 2009. That compares with operating earnings of $1.81 a share in fiscal 2007. Yet Discover doesn't seem to be taking the clobbering of some of its peers. American Express, for example, shocked Wall Street in July when it announced a greater-than-30% earnings drop in the second quarter, compared with both consensus forecasts and the year-earlier number.

The credit card tsunami will pass in time. And this cycle may prove to be somewhat less lethal than expected because so much of the bad consumer debt that would normally have savaged the card industry was instead rolled into home mortgages during the refinancing boom of 2003-2006.

Discover learned credit conservatism the hard way. After gunning growth in its card issuance and account balances in the late '90s, Discover paid for its excesses over the next three years, culminating in net charge-offs of 6.6% in 2003.

This time around, Discover consciously lowered its exposure to geographic areas where insensate mortgage borrowing had driven debt-to-income ratios to absurd levels. According to securitization data collected by Portales Partners, only 15.8% of Discover's receivables are concentrated in the mortgage graveyards of California and Florida, while American Express has a 25.9% exposure and Citigroup and Capital One have concentrations of 21.7% and 18.7%, respectively. Among other things, American Express made the fateful mistake during the current cycle of assuming that households with multiple mortgages represented better credit risks.