Discover's in a Sweet Spot

Over the long run, Discover Financial Services’ DFS unique role as a credit card lender focused on Middle America, operating its own network, puts the company in an interesting strategic position. In the short term, we view Discover’s prospects less favorably as the heated rewards environment means customer acquisition costs will weigh on margins. In addition, as competition intensifies, Discover’s larger rivals can exploit their scale on national advertising campaigns and technology spending.

Despite the size advantages of its rivals, Discover is consistently one of the most profitable banks on the basis of return on equity. This is largely attributable to two advantages. Because Discover isn’t a systemically important financial institution, it can hold less capital than its larger rivals relative to its loan book composition. Discover’s assets stand at more than 9.5 times equity. The second-biggest contributor to the company’s outsize returns is business mix. Credit card loans account for nearly two thirds of the bank’s total assets. These high-yield loans drive the bank’s exceptional net interest margins, which routinely exceed those of money center banks by 600 basis points. These advantages have routinely enabled Discover to earn returns on equity near 20% and repurchase more than 5% of its shares each year.

Over the long run, it will be interesting to see how Discover exploits the advantage of being an issuer while operating a payment network. This position means Discover can more easily offer cashback rewards debit cards, which could help it build a cheaper source of deposits. Currently, Discover’s funding depends heavily on CDs and money market accounts and competes for deposits primarily on rates, which means the bank is at a disadvantage when it comes to funding.

The bank talks at great length about its direct banking model, but so far, we haven’t seen this enable Discover to acquire customers more efficiently. If the bank is serious about building a digital bank, it must be willing to make the investments that could weigh on its margins. Thus far, we have seen only limited evidence that the bank is making these investments.

Higher Switching Costs Contribute to Impressive Returns In our opinion, Discover Financial has earned a narrow moat. Of the credit card companies, Discover is most comparable to American Express AXP in that it generates net interest income primarily on credit cards and operates a highly profitable payment network. However, Discover is much more reliant on interest income, which accounts for approximately 80% of net revenue. In contrast to Amex's collection of high-spending and lower-risk cardholders, the typical Discover cardholder is a middle-income American much more likely to hold a balance at the end of each month. In addition to Discover's credit card operations, the bank's PULSE network is one of the country's largest debit and ATM networks.

Discover exhibits many of the hallmarks of credit card companies, with net interest margins in the upper single digits and returns on equity in the high teens to low 20s. It is indeed still a very good business model to borrow at low-single-digit rates and lend to consumers at rates often 10 percentage points higher than the cost to borrow. We believe Discover’s impressive returns are partly a function of the higher switching costs incurred by cardholders with revolving balances each month. Cardholders who have existing balances are usually considered comparatively more risky by competing issuers and usually cannot lower their interest rate by consolidating with another credit card issuer, since transferring a balance often results in a higher or comparable rate. This inability to achieve a lower interest rate is the main switching cost. This means once Discover obtains a customer that revolves, it’s likely to generate years of interest income on high-yielding balances. It is here where Discover generates excess returns, which we anticipate will remain for the foreseeable future.

However, it is not easy for Discover or any credit card issuer to assemble a portfolio of high-yielding cardholders who carry revolving balances. Discover must offer generous rewards to a large pool of consumers, many of whom will never keep a balance and never be profitable, and incur losses from weaker cardholders who never pay their bills. This is a multiyear process and investment that many competitors are unwilling to endure because the initial costs are considerable. Because Discover operates at a smaller scale than American Express, Citi C, JPMorgan JPM, and Capital One COF, it does not enjoy the same cost advantages of advertising on a national scale. In addition, Discover’s smaller scale and limited ability to sell additional products means the company has less ability to offer the same level of rewards as its rivals. Furthermore, given that its rivals are traditional banks with cheaper deposit funding, Discover is at a cost disadvantage and much more vulnerable to a rising rate environment. Though we do think Discover would still have the ability to raise rates on existing cardholders, higher rates would affect Discover more than its rivals. Should rewards continue to accelerate and larger rivals view credit card promotions as a loss leader, we doubt Discover would continue to be able to match the rewards and promotions of larger competitors operating with a cheaper cost of funding. That means Discover would be left with a high-return credit card portfolio but limited prospects for growth.

In addition to its revenue from interest income, Discover operates its own credit and debit payment network where it runs into Visa V and Mastercard MA, which operate in a much larger collection of geographies. Though this is a high-return business requiring minimal ongoing investment, Discover’s network can only maintain its value if it continues to attract users of Discover cards. In North America, Discover is the third most widely accepted card, trailing only Visa and Mastercard. In the United States, cardholders should not have much trouble getting merchants to accept Discover. However, outside the U.S., Discover holders have much more trouble using their cards. The ability to use a card internationally is a necessity for a key segment of the market. Many users will not care that they may have trouble using their Discover card in a country they’ll never visit. However, Discover’s acceptance gap abroad does inhibit the company’s ability to attract high-spending, low-revolving consumers. In addition, it means fewer businesses will adopt Discover’s Diners Club as the company credit card. We believe Discover benefits from the network effect, but given its smaller size and user base, this moat source takes on significantly less importance than it does for American Express. As technology advances and new forms of payment are accepted, it is conceivable that fewer merchants will accept Discover.

We are intrigued by the potential for Discover to use its payment network to offer debit cards that offer rewards. This could result in Discover constructing a low-cost deposit base of checking accounts. However, if people start opting to use debit cards rather than credit cards, this could eat into Discover’s ability to generate interest income.

Finally, Discover is a leading provider of student loans. We view student lending as mostly a commodity business with limited competitive advantages for any competitor. In addition, the company has tried to build the foundation for its direct-to-consumer banking platform. We believe these efforts into more traditional banking services are a good strategic idea, but it’s still very early in their development. Thus, we don’t believe this segment contributes anything to the company’s narrow moat.

Technology Is Greatest Risk Discover's biggest risk is advances in technology that enables merchants to bypass legacy payment systems like Visa, Mastercard, and Discover. In addition, we think mobile technology enables retailers to more easily operate their own closed-loop networks, which would entirely bypass the traditional networks.

Discover’s returns are partly driven by the overall health of the U.S. consumer. If consumer spending declines, we would anticipate Discover’s fee revenue to take a hit while credit card charge-offs rise.

We regard Discover’s stewardship of shareholder capital as exemplary. The company has a solid balance sheet that gives it the flexibility to deal with the ebbs and flows of the economy. With assets that stand at more than 9.6 times equity, Discover’s leverage does exceed peers’. However, this doesn’t cause us too much concern. Even during the 2008 financial crisis, Discover remained profitable. Currently, the only risk we see is that in a downturn Discover may have to slow repurchases. Over the last five years, Discover has been able to reduce its share count by nearly 30%.

Almost 70% of Discover’s total funding is derived from deposits. When it comes to attracting deposits, Discover is mostly competing on price. As rates rise, Discover should feel the effect of its comparatively expensive deposit base.