April 2010: Volume 1, No. 3

What to buy: Discover Financial Services (NYSE: DFS)

Why should I buy? Credit card issuer and payment processor with credit losses below industry averages. Strong growth from banking, global payment processing and direct lending initiatives.

Why now? The consumer credit cycle is turning for the better with signs of improved spending trends and falling charge-offs and delinquencies. Discover will benefit as it’s able to reverse credit reserves.

What is the target? Buy up to $16.75, stop at $12.40. Looking for a rally to around $23.

Yiannis returned to his native Greece to celebrate Easter, so this month’s Stocks on the Run meeting was conducted by telephone. Deciding it was time to enjoy the spring-like weather here in Alexandria, Virginia I collected my stack of notes and walked to my favorite neighborhood Italian restaurant, A la Lucia, to sit on their patio. I ordered a coffee and dialed Yiannis’ mobile phone.

Yiannis: Nai?

Elliott: “Nai” to you too.

Yiannis: Hey man, you’ll never guess where I am.

Elliott: Greece?

Yiannis: Very funny. I’m sitting at 21.

That brought back fond memories of my trip to Greece last summer. 21 is the hotel I stayed in while visiting Yiannis in Athens.

Elliott: I miss that place, great Chateaubriand.

Yiannis: That’s true but you’re still famous here for those gin and tonics you were drinking…

Elliott: What, you lot have something against a gin and tonic?

Yiannis: No, just most people actually put some tonic in their gin and tonics…

Elliott: Tonic is just filler…but enough of the chatter, this call is going to get expensive.  Let’s talk about credit and I’m not talking about your government’s little sovereign debt debacle. I’m talking about consumer credit and, in particular, credit cards.

Yiannis: Even worse. Didn’t the credit card boom die with the housing bust?

Elliott: True man, back in 2006 and ‘07 the issuers lent money to anyone with a pulse. And, they’ve been paying for that mistake with high delinquency and charge-off rates through the economic downturn. But…

Yiannis:  Didn’t the government just introduce a new law…

Elliott: Stop interrupting and let me finish, I’ll get to all of that. The case for buying a credit card issuer isn’t that delinquency and charge-off rates are low; it’s that they’ve already peaked and they’re now falling.  The worst quality borrowers have already defaulted on their debts and those loans have been reserved for and charged off the books. The borrowers who remain have at least been making their payments all through the recession – they’re not deadbeats.

American Express has been reporting a gradual improvement in credit quality since the middle of last year.

Yiannis: I got your e-mail about Discover and they’re no American Express. Why not buy AMEX?

Elliott: You’re right, AMEX customers tend to be higher quality borrowers than most of the banks deal with. But that’s exactly my point – AMEX delinquency trends always lead the industry by several months and that’s happening this time around too.

AMEX began to report improvement last summer and Discover is just starting to show a fall in delinquencies and charge-offs. Even better, in most years delinquency rates rise in the first quarter because borrowers struggle to pay off the debt racked up on holiday shopping sprees. This year, delinquencies actually declined in the quarter, a sign that the credit improvement is even stronger than usual. The credit cycle is turning and Discover is a leveraged play on the trend.

Yiannis: How about the Credit Card law? Isn’t the government prohibiting a bunch of the fees and charges that made the credit card issuers so much money?

Elliott: The Credit Card Act is a headwind for all the card issuers. But, we’ve known about the Card Act for months so the effects have already been priced into the stocks. And the final bill wasn’t as bad for the industry as some feared.

Discover has already taken steps to address the issue. For example, the law places restrictions on making changes to interest rates covering existing balances but Discover re-priced much of its existing business before the law went into effect and shifted most of its loans to variable rates.

Yiannis: When you sent me the information on Discover, I couldn’t help but notice they actually lost money in the first quarter. What does that do to your credit cycle theory, eh? Can we really recommend a company that’s losing money?

Elliott: I knew you’d ask about that. Actually, this plays right into one of the main reasons I like the stock. That loss is mainly an accounting issue, not an actual loss.

Discover maintains a reserve to cushion itself against losses on its loan portfolio. In the wake of the credit bust in 2007, lenders began to get more conservative about their reserves, holding larger reserves to cover outstanding loans.

In the first quarter, Discover took an additional $305 million in reserves– if we net out the reserve addition the company didn’t really lose that money.

As credit quality continues to improve this year, Discover is likely to take some of that money out of reserves. Just as higher reserves hit results over the last year, taking money out of reserves and adding it back to earnings will boost results in 2010.
If they were really in poor financial shape they wouldn’t be planning to repay their TARP loans this quarter.

Yiannis: OK, I like it let’s…

Elliott: Hold on, I have another. Like AMEX, Discover isn’t just a card issuer but a card processor. Discover is much smaller than Visa, MasterCard and AMEX but it’s been growing quickly in recent quarters partly thanks to the fact that the VISA and MasterCard antitrust case opened up the market to more competition. They’re also expanding internationally, partnering with local issuers in countries like Japan and South Korea. International sales trends are far better than the US.

And Discover has attracted nearly $15 billion in deposits, a low cost source of capital.

Yiannis: I like it. I also noticed that Discover is a leader in the cashback rewards business, a good niche play. So, let’s send the recommendation and I’ll see you next week.

Elliott: Wait, before you go, I have another proposal. I’ve been in enough London casinos to know that you Greeks love an occasional friendly wager.

Yiannis: Yeah…

Elliott: We have two recommendations out for Stocks on the Run and both are doing well. But, let’s make it more interesting — Dinner and drinks says that my Intrepid Potash pick ends up making more than your play in VanceInfo Technologies. After all, this service was built on a friendly competition.

Yiannis: You’re on. And I say we have the dinner right here at 21 in July, a bottle of champagne, some of your gin and a full meal.

Elliott: The Race to 21, I like it. It’s a bet. Cheers, see you next week.

Buy Discover Financial (NYSE: DFS) up to $16.75, place a stop at $12.40.





Follow up on open trades:

Buy Intrepid Potash (NYSE: IPI) under $31 with a stop at $25.75.

Buy VanceInfo Technologies (NYSE: VIT) under $23.50 with a stop at $15.75.

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