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Thursday, April 24, 2014 - 09:30
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Thursday, April 24, 2014 - 09:30

The Best Credit Card Stock You Can Buy

Thursday, April 24, 2014 - 9:30am

When a company is referred to as a "poor man's American Express (NYSE: AXP)," it may seem like a backhanded compliment.

But it's a fair analogy for Discover Financial Services (NYSE: DFS). The credit card issuer and financial services firm caters to a middle-income demographic, a clear peg down from AmEx's focus on upper-income consumers and small businesses.

But Discover's management takes a backseat to no one when it comes to delivering robust and shareholder-friendly moves. Based on recent actions, Discover is emerging as one of the top Total Yield plays of 2014.

Discover has seemingly always been on the margins of the financial services industry, never holding dominant market share in any of the niches in which it operates. Sears Holdings (Nasdaq: SHLD) launched the company in 1985 and eventually unloaded it to Morgan Stanley (NYSE: MS), which eventually disposed of it through the IPO market (in 2007).

Yet through it all, Discover's management has built a very respectable franchise. CEO David Nelms has been in charge for a decade and gets high marks from analysts. "The company has made great strides during his tenure, and Discover's relatively high capital levels and excellent underwriting kept the company in good shape throughout the financial crisis," writes Morningstar's Jim Sinegal.

Many people may overlook the Discover card, as it toils in the shadow of Visa (NYSE: V), MasterCard (NYSE: MA) and AmEx, but the Discover card is actually experiencing industry-leading growth right now (on a percentage basis) in new accounts and transaction volume.

More impressive, Discover's online banking and lending business is now delivering industry-leading profit margins. "Without the cost burden of a branch network, Discover has become a leader in direct consumer banking. We think the ability to both raise deposits and make loans online cuts out an important layer of costs relative to peers, and Discover has arguably focused more than any other company in this area," note analysts at Morningstar.

Flickr/Dino Husejnovic
Many people may overlook the Discover card, as it toils in the shadow of Visa, MasterCard and AmEx, but the Discover card is actually experiencing industry-leading growth right now (on a percentage basis) in new accounts and transaction volume.

More recent forays into mortgage underwriting, student loans and home equity lending have come at a time when many existing players have been retrenching, enabling Discover to quickly gain market share. Those moves, coupled with Discover's efforts to more deeply coordinate with alternative payment providers such as PayPal and China UnionPay, should help generate rising sales and profits as U.S. consumer spending finally starts to strengthen.

Even before then, Discover's financial performance has already been quite impressive: The company has averaged $3.3 billion in annualized free cash flow over the past five years. The impressive free cash flow has enabled Discover to boost its Tier 1 common capital to 14.9%, which is the highest in the sector and well above the legally required minimums. As a result, management aims to reduce this metric to 11% by the end of next year, and to do so, will return cash to shareholders at a faster pace.

Discover recently completed a $2.4 billion share repurchase program, and just this week, announced a new $3.2 billion buyback program, which could shrink the current float by more than 11%.

Also, the dividend is getting a lot more attention these days. Since being spun out from Morgan Stanley in 2007, the payout had never grown above $0.20 a share -- but it surged to $0.74 a share last year, is at a $0.96 a share run rate this year, and could be heading to $1.16 a share by next year, according to Merrill Lynch. That 2015 projected payout only equates to a 2% yield, but when coupled with the massive buyback plan, works out to be a Total Yield exceeding 13%.

Analysts see real virtue in Discover's financial strength: "DFS continues to be our top pick amongst the credit card issuers as we believe the company will continue to have stronger balance growth than its peers which will ultimately benefit the company when interest rates rise," note analysts at Credit Suisse.

Incidentally, that "poor man's AmEx" notion also comes into play in terms of valuations as well. Shares of AmEx trade for around 14.5 times projected profits, while Discover's multiple is just 10. Discover's 2.6 times price-to-book ratio is also roughly half as large as AmEx's ratio.

Risks to Consider: Consumers are handling their finances in a prudent fashion these days, though a firming economy may see a return to the day of more reckless lending and rising bad loans.

Action to Take --> You never hear about Discover when the media talks about the nation's credit card issuers or top banks. Discover's hybrid business model may get some to the blame as the company is hard to categorize. But a deep look at this financial firm's key operating metrics reveals a top-class operator with leverage to a resurgent U.S. economy.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.