Five Reasons It May Pay to Discover

I don't know, and Discover is a much smaller company with a smaller market. But I see at least five reasons why this quiet rollout may pay off:

• Attractive niche: Discover appeals to a wealthier clientele attracted to the "cash back bonus" incentives of 1% or more, among other things. As a result, DFS is more immune to credit-risk issues and write-offs affecting the industry at large.
• Loyal customers: A recent study by industry service provider Cardweb showed Discover cardmembers hold their cards for an average of 8.6 years vs. a 6.2-year industry average. The 4.5% attrition rate is half the industry average. The lower customer churn keeps costs down and gives better opportunities to grow cardholders into more profitable customers.

  Discover also recently won the "Brand Keys" Customer Loyalty award for the credit card industry for the 10th straight year. It is also indicative of -- or probably a result of -- better customer service, which I can attest to from my own experience. Better customer service in any commodity industry is a competitive advantage.

• Strong cash position and cash flow: According to filings, the company generates some $1.5 billion in cash flow on a market cap of about $12 billion, a price-to-cash-flow ratio of 8. Although there isn't much data to go on, the price-to-earnings ratio looks destined for the 12 to 14 range.

  And there's plenty of cash on the balance sheet, too (thanks, Morgan Stanley) -- almost $8 billion, or about $16.50 a share. Now there is also $5 billion in debt, but in this industry, the use of debt to finance receivables is normal, and the $3 billion left over still amounts to more than $6 a share, strong on a $26 stock.

• Flexibility of independence: For most of its life Discover has been under the thumb of a larger corporate parent -- Morgan Stanley and Sears (SHLD Quote - Cramer on SHLD - Stock Picks) before that. I anticipate new freedom to implement strategies and allocate capital according to its own instincts will lead to exciting things.
• Improving industry fundamentals: The migration away from cash and checks to debit and credit cards (and Discover provides both) bodes well, especially in this wealthier customer segment likely to spend more.

Now to be sure, there are some negatives. Discover only owns some 5% of the credit-card market, and it is an industry that prospers on scale to absorb fixed costs. But that can also be an advantage -- again, flexibility and the ability to concentrate on profitable niches. And it only has a tiny international presence, but that could also be perceived as a growth opportunity.

Frequently such spinoffs are greeted with initial selling, as holders of the original shares (Morgan Stanley, in this case) cash out or adjust their portfolios to eliminate the new noncore business.

It appears that's what happened here. DFS opened at $28.55 on the day of the rollout, and dropped steadily to a low below $25 on July 11.

It may not follow MasterCard's trajectory, but I believe this company could become one of the better portfolio discoveries this year.

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