Why It Should Pay to Discover

Phil Guziec: Hi, I'm Phil Guziec, co-editor and portfolio manager of Morningstar's OptionInvestor newsletter and research service, and I'm here with Michael Kon, senior analyst covering Discover Financial Services.

Hi, Michael. Thanks for joining us. So we've recommended a quick-shot investment idea on Discover Financial Services. We're buying the upside tail, as we like to call it. We're buying at a $20 strike call. The stock is trading in the mid-teens. You think it's worth $27, which means more like $32, in January 2012, when our call expires.

So I just wanted to get the background on the company, why it's a great company, why you think it's worth $27, and the chances that we're going to break even or better on our investment. Starting out with the basics, Discover is one of four major credit card networks.

Michael Kon: Discover operates a credit card network. The network is a closed loop network, which means that Discover is both the credit card issuer and the card processor. It services both credit card holders and merchants.

Guziec: And they're also in the lending business.

Kon: That's right. Part of the services they provide to credit card holders is lending them on their credit cards, providing them with credit lines to fund their purchases.

Guziec: The share price of Discover is currently pretty depressed, and there's a few reasons for that. I think the first one is the lending business?

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Kon: Yes, the lending business faces some regulatory concerns. The Credit Card Act was introduced last year and went into effect a few days ago. I think the market is concerned how the credit card issuers will handle the new rules that were imposed on players in this market.

Guziec: And then what about current earnings in the lending business?

Kon: The lending business currently faces some cyclical headwinds. Although the recession officially ended, unemployment is still very high, and that causes charges to remain high.

Guziec: And then the transaction volumes are affected by the recession as well, right?

Kon: Yes. What happened in this recession is that consumer spending was hit very hard, especially the discretionary spending. Individuals in the U.S. and globally went from a spending mode to a saving mode, and as a result, credit card volumes all over the world declined.

Guziec: It sounds like all three of these clouds are temporary, that Discover shares should eventually be generating normalized earnings. We don't expect any bankruptcies, and you've been telling me not to be too worried about these legislative changes' impacts on earning power. Is that correct?

Kon: I think Discover is one of the firms that are best positioned to deal with the new rules. Most of the practices that were banned by the new rules, Discover never practiced them, and with others, it just will level the playing field for Discover and will make the competition in this space fair.

Guziec: So this legislation actually may be a little bit of a tailwind for Discover going forward.

Kon: It helps them in some areas, and it might be costly in others. But overall I think Discover is well positioned to deal with the new rules.

Guziec: So your $27 fair value, which implies about a $32 fair value by the time our options expire, is pretty aggressive and describes a pretty significant upside tail. I suppose if that's what you expect, there's a chance the valuation could be above that as well.

What do you think the chances are that our option position, which makes money if Discover closes above $21.40 at the end of January 2012, is going to do better than break even?

Kon: I think Discover is well positioned to deal with the cyclical headwinds it's facing, so that I think the chances for this trade to work out are over 50 percent. I think the most recent trends that we see from both businesses are positive, and the likelihood of positive outcome is high.

Guziec: Great. Thank you, Michael. I'm Phil Guziec, co-editor and portfolio manager of Morningstar's OptionInvestor. We encourage you to join us for other interesting, deeply researched option investing ideas at Option.Morningstar.com.