Discover Has 35%-40% Upside: Analyst

NEW YORK (TheStreet) -- Shares of Discover Financial Services (DFS) should trade at a much higher multiple to forward earnings estimates and as a result are considerably undervalued by the market, according to William Blair analyst Robert Napoli.

Discover's stock closed at $40.58 Tuesday, trading for 9.0 times the consensus fiscal 2014 earnings estimate of $4.50.

Napoli upgraded Discover to "outperform" from "market perform," saying in a report on Wednesday that the "shares should trade in the mid-$50 range, or about 13 times our conservative 2015 EPS estimate of $4.23, which we consider "normalized earnings," versus the current valuation of 9.6 times on 2015 EPS." Such a valuation implies roughly 35-40% upside in the shares.

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Discover's shares were up 5% year-to-date through Tuesday's close, following a 63% return during 2012. But "the valuation still does not give credit for the true franchise value and the proven strength of the management team," Napoli wrote.

A quick look at Discover's very strong earnings performance illustrates just how low the forward price-to-earnings ratio is.

For fiscal 2012 ended Nov. 30, the credit card lender reported net income available to common stockholders of $2.3 billion, or $4.47 a share, increasing from $2.2 billion, or $4.06 a share, the previous year. The company's return on average assets (ROA) was 3.23% in fiscal 2012, and its return on average tangible common equity (ROTCE) was 26.8%, according to Thomson Reuters Bank Insight.

With its focus on credit card lending, Discover's ROA has ranged from 1.20% to 3.43% over the past five fiscal years, while the ROTCE has ranged from 12.7% to 26.8%. During that period, the "weak year" for ROTCE was fiscal 2010, when Discover set aside $3.2 billion for loan loss reserves.

The low forward P/E ratio puts Discover's stock at a similar valuation to the "big four" U.S. banks, which lack Discover's focus on credit card loans. Such loans made up 82% of the Discover's loan portfolio as of Nov 30.

• Shares of Citigroup (C) closed at $43.60 Monday, trading for 8.4 times the consensus 2014 EPS estimate of $5.20. Excluding 2008, when Citi lost $27.7 billion, the company's ROTCE has ranged from negative 1.33% to 8.04% over the past four years, according to Thomson Reuters Bank Insight.
• Bank of America (BAC) closed at $11.55 Tuesday, trading for 9.0 times the consensus 2014 EPS estimate of $1.29. The company's ROTCE over the past five years has ranged from a negative 1.75% to 8.20%.
• JPMorgan Chase (JPM) closed at $49.49 Tuesday, trading for 8.5 times the consensus 2014 EPS estimate of $5.82. The company's ROTCE over the past five years has ranged from 6.89% to 15.26%.
• Shares of Wells Fargo (WFC) closed at $35.88 Tuesday, trading for 9.2 times the consensus 2014 EPS estimate of $3.89. Wells Fargo has had the best earnings among the big four, with ROTCE ranging from 8.97% to 18.02% over the past five years.

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Despite his upgrade, Napoli believes Discover is "overearning." He points to "credit losses at an all-time low and margins at attractive levels," and believes the company will build its loan loss reserves over the next several years. The analyst estimates that Discover will earn $4.56 during fiscal 2013, with earnings declining slightly to $4.50 in fiscal 2014, declining further to a "normalized" level of $4.23 in fiscal 2015.

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