Discover Financial Services announced that it has reached an agreement with the FDIC and CFPB over the marketing of credit protection products and will refund $200 million to customers and pay a $14 million penalty. Some investors think this is a positive outcome to this previously disclosed matter and while some additional changes to the company’s marketing practices are likely, we don’t expect them to have a material effect on revenues or earnings. Analysts estimate that the payment protection products in question account for only about 3% of revenues after significant changes to marketing late last year. Perhaps investors realize the charge does not move the needle, because shares are currently up on the news.
We do not know the fine details of the case, but it seems slightly strange. Anyone who possess a credit card knows that the company always tries to sell credit protection, which is totally unnecessary. In almost all cases, the customer is not liable for credit card fraud committed by other individuals. This applies to American Express Company (NYSE:AXP) Discover, Mastercard Inc (NYSE:MA), Visa Inc (NYSE:V) & other credit card companies alike. It is almost standard procedure to try to sell some type of fraud protection to existing or new card holders. Discover is no exception to this practice.
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Goldman Sachs (NYSE:GS) has actually upgraded Discover Financial Services (NYSE:DFS) on the news, with a price target of $46.
(1) Upside from structurally lower losses. Our work suggests that in the longer term, when charge-offs normalize, Discover Financial Services (NYSE:DFS)’ card losses will be structurally lower at 4-4.25%, well below the 5%+ industry historical average, given better underwriting and less sub-prime. That said, we see near-term losses remaining below 2.5%, driving upside to consensus.
(2) NIM and excess capital both underappreciated. We see funding repricing providing NIM stability and/or upside through year-end 2013, which if executed could add 25+ bp to consensus 2013E margins. We also believe deployment of DFS’ excess capital position should be $1.50-$2.00 additive to EPS over time under a variety of deployment scenarios.
(3) Normalized estimate of $4.50. Our work suggests DFS can earn $4.50 in a normal environment even with higher losses and lower NIM, providing strong uplift from the current $4+ run-rate. Our assumptions are conservative and with minor ROI tweaks, we could add another $0.50.
We raise our price target to $46 (10.3X our normalized EPS of $4.50) from\ $41. We raise our 2013/2014E EPS to $4.18/$4.25 (above consensus) from $4.10/$4.10 on lower losses and a better NIM.
Goldman also notes, while some skeptics question the need for DFS to own and operate a network given its lower scale (5.4% US market share) relative to the larger networks, American Express Company (NYSE:AXP), Mastercard Inc (NYSE:MA), and Visa Inc (NYSE:V) they see value in its agreement with eBay Inc (NASDAQ:EBAY)’s Paypal.
In the last six years, Discover has signed six major network partnerships, including the recently announced agreement with eBay Inc (NASDAQ:EBAY)’s PayPal. Goldman views the partnerships as strengthening Discover’s network, but they think further alliances are needed to help monetize the network, which we believe is key. PayPal partnership could be 2-3% additive to EPS.
Additionally, American Express Company (NYSE:AXP) Visa Inc (NYSE:V) and Mastercard Inc (NYSE:MA) multiples imply DFS’ network is worth $7-$9. Applying a ratio of market cap to global volume similar to that for Visa Inc (NYSE:V) and Mastercard Inc (NYSE:MA)(1.6% average) implies that DFS’ network business ($280bn in global volume) should be valued at $4.5bn or $8.58/share.
(Disclosure: the author of this article is long AXP, no other positions in any securities mentioned)