The credit card business, also known as payment processing, is dominated by the duopoly that is Visa (NYSE:V) and Mastercard (NYSE:MA). These two companies control about 80% of the market, with Visa being the bigger of the two.
The rest is split between American Express (NYSE:AXP) and Discover Financial Services (NYSE:DFS). These two players are different from Visa and Mastercard in that they have closed-loop networks, meaning that they are the lender, issuer and processor. However, Visa and Mastercard simply process payments on their massive networks in exchange for fees. They donʻt lend or issue cards directly.
Being a closed-loop network has some benefits, but it also brings some challenges. Letʻs take a look at the smallest of the four major payment processors, Discover Financial. Is it a buy?
Discover the differences
As mentioned, Discover is different from the big two, but there are also key differences between it and American Express. The primary one is that it makes most of its money in interest income from loans being repaid, while American Express makes more on fees charged to merchants and annual memberships fees.
As such, Discover is much more of a bank than the other three. For example, in the third quarter, about 82% of its $4 billion in net revenue came from interest income. As a result, Discover’s overall revenue was up 17% in the quarter on higher card yields and a 17% increase in loans. That is one of the key benefits for Discover; it can take advantage of higher interest rates to generate higher net interest income.
The downside is that it has more credit risk due to the potential of customers defaulting on their loans. Case in point, the total net charge-off rate jumped 181 basis points year over year to 3.52% in the quarter.
Charge-offs refer to debt or loans that wonʻt be repaid. The credit card net charge-off rate was even higher, up 211 basis points to 4.03%. Looking further out, the delinquency rate for credit card loans lasting 30 days or more was up 130 basis points to 3.41%. This is likely because the economy is dealing with elevated inflation and high interest rates.
The bottom-line impact of rising credit risk is felt in the provision for credit losses, which a lender must set aside for expected future losses due to loans not being repaid. These provisions rise in what is expected to be a more difficult economic environment, like next year, and that takes a bite out of earnings.
For example, Discoverʻs provision for credit losses jumped to $1.7 billion in Q3, up from $727 million in the third quarter of 2022. That resulted in a 33% year-over-year drop in quarterly net income to $683 million.
That money could come back in the form of a reserve if the economy ends up being better than expected and the delinquencies that have been anticipated don’t actually happen. However, that wonʻt be known until down the road.
Changes are coming
Discover has had a solid year overall, as its net interest income is up 21% through the first nine months while its revenue has gained 22%. However, higher provisions have resulted in a 24% drop in net income. Nonetheless, Discover’s share price is up by about 13% year to date (YTD) as of Dec. 21.
There are some changes afoot at the company that could result in its stock price popping in 2024. The big one is that Discover is looking to get out of the student loan business. While credit cards are the major source of revenue, Discover also does personal loans and student loans, and the latter have been lagging. In late November, Discover said it would stop originating student loans on Feb. 4, 2024 and was exploring the sale of its student loan portfolio.
“During a recent review, the Board determined that exploring the sale and transfer of servicing of Discover’s student loans is aligned with those priorities, better enabling Discover to focus on our core banking products, capitalize on our growth opportunities and deliver long-term shareholder value,” said John Owen, Discover’s interim CEO and president.
The company has also hired a new CEO, Michael Rhodes, who comes over from Toronto-Dominion Bank (NYSE:TD), where he led the Canadian Personal Banking division. He will take the helm at Discover in March 2024.
Price jumps on an upgrade
This week, Discoverʻs stock price jumped after Citigroup (NYSE:C) raised its price target to $133 per share and gave it a buy rating. To reach $133, Discover stock would have to increase about 19% from current levels.
Citigroup analysts cited the sale of the student loan portfolio as a major catalyst, saying it should boost earnings, streamline operations, enhance liquidity, and be accompanied by a significant share repurchase program. They also see credit losses peaking in 2024 as rates start to come down in the back half of the year.
These are all positives for Discover, as is its low valuation, trading at just over seven times earnings. I think at this valuation with these catalysts and an improving economy in the back half of the year, it should be a fairly decent buy.
Disclaimer: All investments involve risk. In no way should this article be taken as investment advice or constitute responsibility for investment gains or losses. The information in this report should not be relied upon for investment decisions. All investors must conduct their own due diligence and consult their own investment advisors in making trading decisions.
