Published:
July 25, 2007
Discover Financial Services (NYSE: DFS, $25.00)
-- Just a few short weeks ago, the Discover
network was still owned by brokerage and investment banking firm
Morgan Stanley (NYSE: MS) -- but no longer.
Morgan Stanley made the decision to spin-off the company several
months ago, and Discover now trades on the NYSE as a
stand-alone entity for the first time. Unlike MasterCard (NYSE: MA), the stock
has been greeted with a lukewarm reception thus far, suggesting that
many Morgan Stanley shareholders have been quick to cash out.
However, as the selling gradually subsides, we think the company
will have some appeal. Though the Discover network trails its rivals
by a wide margin in terms of cardholders, spending volume, and
merchant acceptance, it does have several advantages in its favor.
Much like the business model of American Express (NYSE: AXP), Discover has
eliminated the middleman and "closed the loop." In other words, the
company issues its own cards, so it not only collects fees from
merchants, but also pockets interest income from cardholders. Other
companies like Visa and MasterCard simply operate the payment
networks and earn transaction fees from merchants, while issuers
like Bank of America (NYSE: BAC) and Citigroup (NYSE: C) actually
collect the interest income. Furthermore, the company has teamed up
with third-party issuers like Wal-Mart (NYSE: WMT), without giving
up interest income. This is a big distribution channel to get
Discover cards in people's pockets, and we expect to see more of
these beneficial arrangements in the future.
Discover may be fourth in a four-horse race, but high barriers to
entry have effectively prevented any new players from joining the
game -- and we think there is ample demand for all four firms to
prosper going forward.
As consumers increasingly turn to plastic payment options, credit
card transactions have climbed around +12% annually. Meanwhile,
debit cards have become even more popular, and this is another key
potential growth driver. Discover owns the Pulse debit network,
which is used by 4,400 financial institutions and nearly 260,000 ATM
machines.
In short, Discover only needs to hold its ground to do well, and
considering the brand has ranked #1 in customer loyalty for the past
ten years in a row, we think it is up to the task. The company
currently boasts a base of more than 50 million card members, many of
which stick with Discover for its award-winning cash rewards
program.
Furthermore, recent studies have shown that nearly nine of every ten
spin-offs outperform the broader market in the two-year period
following the spin-off. We think DFS has a good chance to be part of
that 90%.
The shares are currently trading at a 17% discount to our $30 fair
value estimate, giving value
investors an attractive entry point.
Nathan Slaughter
Editor
Half-Priced
Stocks
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Nathan's educational background includes NASD series 6, 7, 63,
& 65 certifications, as well as a degree in Finance/Investment Management.
He currently resides in Shreveport, LA with wife Julie and sons Aidan and Riley.
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