Are “Other” Credit Card Stocks a Buy?

The credit card business, also known as payment processing, is dominated by monopolies called Visa (NYSE:V) and Mastercard (NYSE:MA). These two companies control about 80% of the market, with Visa being the larger of the two.

The rest are American Express (NYSE:AXP) and Explore financial services (NYSE:DFS). These two companies differ from Visa and Mastercard in that they have closed-loop networks. That means they are lenders, issuers, and processors. However, Visa and Mastercard simply process payments on their large networks in exchange for a fee. They do not lend or issue cards themselves.

Although closed-loop networks have some advantages, they also present some challenges. Let’s look at Discover Financial, the smallest of the big four payment processors. Is it a purchase?

Discover the differences

As mentioned earlier, Discover is different from the two major services, but it also has key differences from American Express. Most importantly, while American Express makes most of its money from interest income from loan repayments, it makes more from commissions and annual fees charged to merchants.

So Discover is much more like a bank than the other three companies. For example, about 82% of its $4 billion in third-quarter net income came from interest income. As a result, Discover’s overall revenue increased 17% in the quarter, driven by higher card yields and a 17% increase in loans. This is one of the main benefits of Discover. You can take advantage of higher interest rates to generate higher net interest income.

The downside is that there is a higher credit risk because the customer is likely to default on the loan. For example, total net charge-off rate was 3.52% in the quarter, up 181 basis points year-over-year.

Amortization refers to a debt or loan that is not repaid. The credit card net charge-off rate rose further by 211 basis points to 4.03%. The delinquency rate for credit card loans exceeding 30 days rose 130 basis points to 3.41%. This is likely because the economy is dealing with high inflation and high interest rates.

The final impact of increased credit risk is felt in credit loss reserves, which lenders must set aside against expected future losses as loans are not repaid. These provisions will increase in anticipation of a more challenging economic environment in the coming year, impacting our earnings.

For example, Discover’s credit loss provisions jumped from $727 million in the third quarter of 2022 to $1.7 billion in the third quarter. This resulted in quarterly net income of $683 million, down 33% year over year.

If the economy does better than expected and the delinquencies you expected don’t actually happen, that money could come back in the form of reserves. But that won’t be known until down the road.

change is coming

Discover had a solid year overall, with net interest income up 21% and revenue up 22% in the first nine months. However, net profit fell by 24% due to increased provisions. Despite this, Discover’s stock price rose about 13% as of December 21 compared to the beginning of the year.

There are several changes afoot at the company that could cause its stock price to skyrocket in 2024. The biggest one is that Discover is trying to get out of the student loan business. While credit cards are its main source of revenue, Discover also makes personal loans and student loans, the latter of which it lags behind. In late November, Discover said it would stop originating student loans starting February 4, 2024, and was exploring selling its student loan portfolio.

“During our recent review, the Board of Directors determined that the sale and transfer of Discover’s student loan services is consistent with these priorities, allowing Discover to further focus on its core financial products, capitalize on growth opportunities, and deliver long-term shareholder value. . said John Owen, Interim CEO and President of Discover.

The company also hired a new CEO, Michael Rhodes, who previously led Canadian personal banking at Toronto-Dominion Bank (NYSE:TD). He will become head of Discover in March 2024.

The price goes up when you upgrade

Shares of Discover soared this week after Citigroup (NYSE:C) raised its price target to $133 per share and gave the stock a Buy rating. To reach $133, Discover stock would need to increase about 19% from current levels.

Citigroup analysts cited the sale of its student loan portfolio as a key catalyst, saying it should be accompanied by increased revenue, streamlined operations, enhanced liquidity and a significant stock buyback program. They also see credit losses peaking in 2024 as interest rates begin to decline toward the end of the year.

These are all positive factors, as is Discover’s low valuation, which trades at just over 7 times earnings. I think this should be a pretty decent buy considering these catalysts and this valuation driven by an improving economy in the second half of the year.

disclaimer: All investments involve risk. Under no circumstances should this article be taken as investment advice or constitute liability for investment profits or losses. The information in this report should not be relied upon for investment decisions. All investors should conduct their own due diligence and consult their own investment advisors when making trading decisions.