Superior service and exclusive network package Discover Financial Apart
This company’s first-rate customer service and extensive payments network isolates it from incumbents and disruptors. Discover financial services
Discover has more room to surpass
I made Discover Financial Services a long shot in October 2019 and the stock has outperformed the S&P 500 by 5% since then. Despite its slight outperformance, I still see an increase in the title.
Figure 1: Performance of long ideas: from publication date to 10/26/2021
What works: While below expectations, Discover revenue grew 2% year-on-year in 3Q21. Importantly, after five consecutive quarters of year-over-year decline, Discover resumed growth in its loan portfolio and total loans in 3Q21 were 1% higher than in 3Q20. Additionally, the company continues to attract new customers and new accounts are up 17% from 2019 levels.
During the pandemic, consumers paid off outstanding credit balances using government stimulus payments and fewer discretionary spending opportunities, improving the quality of Discover’s loan portfolio. The company’s net imputation rate fell from 3% in 3Q20 to 1.5% in 3Q21. Discover’s 30-day delinquency rate fell 43 basis points year-on-year in 3Q21.
Discover operates an extensive payment network in over 200 countries that is second to none than other major Visa credit card companies
Discover increased its share of unpaid balances from 7.6% in 2019 to 8.2% in 2020. The company’s high-level customer service, as evidenced by its customer satisfaction rankings, fosters strong customer relationships that create competitive advantage. When coupled with Discover’s payment network, the company has a wide gap that allows it to take market share from incumbents while protecting its business from new entrants in decentralized finance (DeFi).
Discover’s established network and deep customer relationships have also kept businesses Buy Now, Pay Later (BPNL) from materializing. My recent report on Affirm Holdings (AFRM) shows that BPNL companies are not replacing credit cards, but simply increasing consumer debt.
Discover’s integrated digital banking and payment model is also more profitable than its direct peers. The company’s rolling 12-month return (TTM) on invested capital (ROIC) of 19% is well above Capital One Financial of peer card issuers
What does not work: As student card and organic loans increased in 3Q21, Discover saw personal loan balances drop 4% year-on-year in 3Q21 as customers quickly paid off outstanding balances during the period. However, personal loans made up only 8% of the company’s total loan balance in 3Q21, and the company believes its return to pre-pandemic underwriting practices for this segment will drive future growth.
Discover felt the pressure of the low interest rate environment in 3Q21, which pushed personal loan yields down quarter over quarter. However, the company’s large credit card portfolio positions the company for continued profitability, even as the current low interest rate environment persists.
Credit cards have traditionally provided a convenient method of transaction, which the proliferation of digital and DeFi payment platforms is now calling into question. Grand View Research expects the digital payment market to grow 19% per year from 2021 to 2028. However, Discover’s wide and secure network and credit facilities can be easily integrated with digital payment platforms. For example, Discover is already leveraging agreements with digital payment platforms such as PayPal.
DFS rated for unusually low earnings growth: Discover’s price to economic book value (PEBV) of 1.0 means the stock is valued so earnings never exceed current levels. For reference, Discover has grown NOPAT by 35% compound annually over the past decade.
Below, I use my inverted DCF model to analyze future cash flow growth expectations built into different stock price scenarios for Discover.
In the first scenario, I assume that Discover:
- the after-tax net operating income (NOPAT) margin falls to 25% (three-year average versus 28% TTM) from 2021 to 2030, and
- revenue increases 2% compounded annually from 2021 to 2030 (vs. consensus CAGR of 6% for 2021-2023)
In this scenario, Discover’s NOPAT grows only 1% compounded annually over the next decade and the share is worth $ 123 / share today, which is the equivalent of the current price. See the math behind this reverse DCF scenario. In this scenario, Discover’s NOPAT in 2030 is only 3% higher than 2020 levels.
Stocks could reach $ 148 or more: If I assume that Discover:
- NOPAT’s margin drops to 27% (vs. 28% TTM) from 2021 to 2030, and
- revenue is increasing at a 6% CAGR through 2023 (same as the 2021-2023 consensus CAGR), and
- turnover increases by 3% per year from 2024 to 2030, then
the share is worth $ 148 / share today – 20% above the current price. See the math behind this reverse DCF scenario. In this scenario, Discover increases the NOPAT by 4% compounded annually over the next decade. For reference, Discover has increased NOPAT by 8% compounded annually for the past five years.
In the above scenarios, I’m assuming a WACC of 9.7%, which is 100 basis points higher than Discover’s current WACC, and working to lower the terminal value in my DCF model in case Discover and / or the credit card companies in general would be disrupted. by DeFi in the medium and long term. If the company continues to beat the competition through its strong customer relationships and the ease of use / availability of its network, this WACC assumption and a lower terminal value could prove to be prudent, in which case DFS has even more advantages.
Figure 2: Historical and implicit NOPAT of Discover: DCF valuation scenarios
Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, industry, style, or theme.