EUR 850.00 For Business Accounts Only

Morningstar | Capital allocation remains a core competence at Discover Financial.

Discover Financial Services can be likened to a "poor man's American Express." Both firms maintain closed-loop networks, issuing cards carrying their brands and establishing direct relationships with merchants, as well as lending to their cardholders. However, American Express generally targets big spenders and makes most of its money from its network, while Discover's customers are primarily middle-class, with the firm relying on lending for most of its profits. Investors should therefore focus their attentions on Discover's banking business. Credit card loans make up roughly two thirds of the company's assets, and deposits fund over half of the bank's balance sheet. Without the cost burden of a branch network, Discover is attempting to become a leader in direct consumer banking. We think the ability to both raise deposits and make loans online cuts out an important layer of costs relative to other lenders, and Discover has arguably focused more than any other company on this area, potentially widening its moat. Management has also taken a cautious approach to balance sheet growth, neither aggressively loosening lending standards nor overpaying for acquisitions. Goodwill and intangible assets accounted for a minuscule portion of the firm's roughly $100 billion balance sheet as of mid-2017. Unfortunately, the online banking business is progressing more slowly than we expected. Discover's efforts to build a mortgage origination platform fell flat, leaving relatively high-risk personal loans and private student loans as the sole sources of balance sheet diversification. Already, hints of risk have sprung up in small segments of the lending business. At the same time, rewards competition has moderated, though rivals may use income tax savings to renew their efforts to win customer spending volume and loan balances. Discover's network segment generates just a small percentage of pretax income, but continues to offer option value to investors in the company's stock. Though regulatory barriers are probably insurmountable for now, Discover's combination of payment and lending businesses could someday be very attractive to a nonbank.