“Inside Value: Spinoff from a Financial Services Giant”

By Travis Johnson, Stock Gumshoe, October 17, 2007

I spent a few minutes yesterday looking at one of the teaser recommendations from Philip Durell’s Inside Value newsletter at the Motley Fool, and it’s time to move on to the second company that he teased.

In the Fool’s words, “It’s another familiar name and a wonderfully run business, but with a twist. You see, this company was recently “spun off” from one of the world’s premier financial services giants.”

Durell believes he has found a pattern of spinoff performance that gives good odds of profitable returns, so this is in part a play on that pattern.

So what else do we know about the company?

It has recently been down on no news or fundamental change — “down some 22% in a matter of weeks.”

Part of the spinoff argument is that the costs associated with separating from their parent company have “masked the company’s massive earning power”

Philip picked another company in this industry in June of last year, and within 13 months the returns to shareholders were 250%.

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So … not enough clues, you say? Nonsense! This is the Gumshoe we’re talking about.

And using both the Thinkitationizer and the Cognolator, in a patented one-two combination, he can tell you that this “blue-chip company at a blue-light special price” company almost certainly is ….

Discover Financial Services (DFS)

This was spun off, as many of you might remember, from Morgan Stanley a couple months ago. You’d think that maybe this was an opportune time for any child to separate from a parent who was about to go through a serious swoon, as Morgan Stanley did at the end of the Summer, but Discover didn’t fare much better. Navellier was one of many who were recommending that you buy Morgan Stanley to capture the breakup value of DFS and MS before the spinoff, but that didn’t work out so well.

Philip Durell has recommended Mastercard before, which is the “other company in the same industry” that’s referred to in the teaser — Mastercard, if you remember, was actually pretty poorly received by the market for a month or two before they started their historic run from $50 to the current price of $150, so if Durell recommended it back in June of 2006, somewhere in the $4o range, those returns have indeed been nice.

Will the same thing happen to Discover? Well, that’s really an open question, in my mind. Discover and Amex have both ranked significantly higher in terms of customer satisfaction than either Mastercard or Visa, but that hasn’t really led to them breaking down the duopoly that those two seem to enjoy … or I guess you could call it a triopoly, though Amex works quite differently from Mastercard and Visa (DFS has a tiny market share, so they’re certainly the odd one out of the major national players).

Lawsuits that DFS and others have filed against Mastercard and Visa, separately or together, for price fixing or collusion or monopolistic practices also seem, to me, to have had limited impact. The businesses are quite different, too, with Discover and Amex both offering most of their cards directly, and therefore having tighter control over the interest rates, other terms, and customer service, while Mastercard and Visa cards are both issued directly by banks who do a lot of their own policy-setting and co-branding (Mastercard was owned by a group of banks before they went public, Visa is a private and tiny payment processing operation, employee-wise, that might also go public before too long).

Discover is certainly not loved at the moment — it may be down around 20% in the last several weeks as the teaser states, depending on what dates you work from, but it’s down more like 30% from when it was spun off from Morgan Stanley and briefly popped over $30 a share. It does trade at a dramatically lower valuation than either AXP or MA, with a forward PE of around 11 compared to about 15 and 25 for the other two, respectively. For an idea of the relative sizes of these companies, AXP is a bona fide mega cap at around $70 billion, Mastercard is around $20 billion, and DFS is the baby at about $10 billion. All three companies pay tiny dividends, with AXP the only one that edges up as high as 1%.

The big negative for Discover, in my opinion, is the tiny market share. According to Cards & Payments, a trade journal, Discover had about 5% of the market last year, versus 44% for Visa, 29% for Mastercard, and 23% for American Express. Even though that’s still a pretty huge dollar volume, you can see how it’s hard to get retailers’ attention with that small a piece of the market — and building these networks is a two-pronged operation, both of which feed on each other: you need to build up large numbers of cardholders to drive demand (“do you take Discover?”), and a need to build up large numbers of merchants, who pay the transaction fees and slap those little Discover stickers on their doors and cash registers, to make sure payment volume grows.

Discover had a nice pop in market share back when they launched, many years ago, because they marketed themselves as the only card offering cash rewards, but now pretty much all the big bank cards have lots of reward programs, so it might be hard for Discover to stand out as anything other than a competitive option that retailers like because it might help keep rates down … and consumers like because they’re not quite as punitive with the interest rates as some banks.

One reasonably compelling aspect of Discover is that it has been beaten down for reasons that may not have much to do with any changing fundamentals of their business — the Wall Street cognoscenti have been haters of Discover for years, and the vast investing punditocracy, analysts included, often suggested that the only way for Morgan Stanley to right their ship was to spin off Discover, which many folks thought was a foolish, expensive lark by MS management. So to some extent, you can argue that MS was essentially forced to offload a company that they had spent billions of dollars building, at just the time that it was of the lowest possible perceived value in the marketplace.

Now that the company has been spun off to those shareholders who thought Discover was part of the problem, it’s probably quite predictable that most of those shareholders sold their DFS shares and thereby drove the price down — and indeed, according to Yahoo Finance, institutional ownership of this one is very, very low at about 5% (seems odd to me — I’d confirm that if it’s important to you).

The big, secular move toward electronic payments and a cashless society around the world is something that I’ve found compelling for some time — but I haven’t personally found a good way to profit from it, other than my delight at not having to carry cash around all the time. We looked into a teaser a while back for Verifone, which also seems like a reasonable idea in this space (they sell the credit card terminals that you see at retailers, among other things), if you’re interested in other plays on this theme — those shares are up about 20% since the summer.

And there’s the macro flip-side, as well — increases in personal bankruptcies, or in the number of people who can’t make credit card payments because their mortgage payments have doubled, would of course be generally bad news for all the players, so it would probably pay to be wary of the subprime and housing crises, and of any downturn in consumer spending or a recession, if you’re in a soothsaying mood.

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I have actually been tempted by Discover before — and I did own Mastercard options for a while, to some profit, but I don’t own any shares in this space now (other than some very far out of the money Morgan Stanley options that have been adjusted to also reflect DFS shares).

If I did decide to buy a credit card company, this is probably the one I would gravitate toward today — they’re in relatively weak competitive position in terms of market share, but they do have a valuable network, smaller though it may be, and they do have satisfied customers and what appears, at least on the surface, to be a bargain valuation. And you can always argue that being the little guy means they might have more room to grow, right? Hmmm, maybe I’m talking myself into taking a nibble here as I type. I’ll have to do some more research.

So … any DFS holders out there? Any Morgan Stanley shareholders who either kept or sold their DFS shares? Why?



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